The efficient market hypothesis states that assets ought to sell for their fundamental values. The fundamental value of a closed-end fund is the market value of its portfolio, the Net Asset Value (NAV). Hence, in theory, the price of closed-end funds should converge to the NAV. It is a well-documented fact, however, that closed-end funds trade at significant discounts or premiums. One of the prevalent explanations for this puzzle argues that, as the scope for arbitrage is limited due to capital account restrictions and transaction costs, the lack of convergence of fund prices to their fundamental value simply reflects the fact that investors in the local (NAV) and foreign (fund) markets differ.1
In this paper, we review the main stylized facts on closed-end country funds in light of an updated data set that includes the Asian crisis period. This allows us to provide a comprehensive characterization of the determination of discounts in crisis periods, study the dynamics of discounts in the aftermath of the Tequila crisis, and compare their behavior during both crises. We present evidence that indicates that investors’ behavior indeed differs for both assets. By accepting this premise, the evolution of fund discounts can be used to shed light on the differential response of domestic and international investors to episodes of financial distress.
We find that the particular pattern displayed by Mexican funds during the 1994 crisis is common to other recent crisis episodes: the price to NAV ratio increases sharply during the initial phases of financial distress. We present evidence that this striking regularity, which we denote as the “closed-end country fund puzzle,” can be attributed to the fact that, in general, international investors are less sensitive to changes in local market conditions than domestic investors (but they are more sensitive to changes in global market conditions). We show that, while the Asian crisis led to significant contagion across all emerging markets, channeled to a large extent through the behavior of international investors, the response from local investors differed. In Asia stock prices declined by more than fund prices (increasing fund premiums), but in Latin America stocks reflected the impact only partially, and hence Latin American fund discounts widened. Hence, substantial declines in local markets in crisis periods exert a less than proportional effect on fund prices, accounting for the sharp decrease in fund discounts. Conversely, a decline in international markets as a result of crises abroad affects fund prices relatively more than local share prices, widening the discount. Moreover, we find that this asymmetric response tends to be highly persistent and hence cannot be explained as a consequence of temporary information asymmetries.
The first policy implication that can be drawn from these results is that less responsive foreign investors may play a stabilizing role in a crisis country, while the opposite is true in contagion countries, where foreign investors are likely to amplify the negative cross effects from crisis economies. A second implication can be derived, according to whether we interpret the asymmetric response as an indication of foreign underreaction or local overreaction. In the first case, and assuming that local investors possess privileged information about local conditions, an increase in the discount may be understood as a signal of the deterioration of local fundamentals.
Instead, we tend to favor the view that crisis premiums reflect local overreaction in the presence of market segmentation. On the one hand, the excessive exposure of local investors to domestic market risk may make them more sensitive to changes in domestic fundamentals. On the other hand, the liquidity crunch that usually follows the unraveling of a financial crisis is likely to have a greater impact on investors in the host country, forcing them to liquidate their local positions at prices below their fundamental value. Therefore, countries that restrict foreign portfolio investment by preventing liquid international investors from operating in the local market may exacerbate the short-term impact of a financial crisis on asset values. Conversely, the presence of internationally diversified foreign investors may amplify contagion in otherwise healthy economies.