The Closed-End Fund Puzzle: Market Secrets Through Behavioral Economics

Exploring the profound impact of human psychology on market prices through the phenomenon of ‘closed-end funds’ that defy traditional economic logic.

• Understand how the Law of One Price breaks down in real financial markets.
• Grasp the unique structure of closed-end funds and their four key puzzles.
• Learn why even rational investors fail to easily correct market inefficiencies.

Why are prices traded differently from known values?

One of the fundamental principles of traditional economics is the Law of One Price. It is a highly rational rule stating that identical goods should have the same price everywhere. However, there is a corner of the financial market where this principle systematically breaks down: the world of Closed-End Funds (CEFs).

Closed-end funds are like transparent jewelry boxes. The value of the jewels inside (the stocks held by the fund), i.e., the Net Asset Value (NAV), is known to everyone. Yet strangely, the market price of the jewelry box itself trades differently from the value of its contents. This article aims to unravel this mystery through the lens of behavioral economics.

1. Law of One Price: The Gap Between Theory and Reality

The force maintaining the Law of One Price comes from arbitrage. Buying cheaply in one market and selling at a higher price in another to earn risk-free profits repeatedly equalizes prices.

However, in reality, this law often breaks due to ‘market frictions’ such as transportation costs, tariffs, and illiquid assets. Closed-end funds are different. The stocks they hold are highly liquid with minimal transaction costs. Theoretically, one should be able to arbitrage by buying discounted funds and short-selling the underlying stocks. So why does this fail? This suggests the problem lies not in simple frictions but in investor psychology and risk.

2. What is a Closed-End Fund?

A closed-end fund raises capital through an initial public offering (IPO) and then trades a fixed number of shares freely on the stock exchange. Its biggest feature is that investors cannot redeem their shares directly from the fund manager at will (no redemption). To recover capital, they must sell shares to other investors in the market.

This ’no redemption’ structure creates space for market prices to drift freely from NAV. In contrast, open-end funds allow redemption at NAV anytime, so price and value always align.

Table 1: Key Differences Between Open-End and Closed-End Funds

3. The Four Puzzles of Closed-End Funds

Examining the lifecycle of closed-end funds reveals four strange phenomena.

Puzzle 1: Why pay a premium? (At Inception)

New closed-end funds start with NAV below the offering price due to issuance costs. In effect, investors pay a premium. Why do investors pay extra for new funds when many similar funds already trade at discounts?

Puzzle 2: Why do they always trade at a discount? (Growth Phase)

The initial premium quickly disappears after IPO, and funds enter a state of persistent discount. For decades, closed-end funds have traded at an average discount of 10–20%. This clearly violates the Law of One Price.

Puzzle 3: Why do discount rates move together? (Volatility)

More intriguingly, discount rates of funds holding different assets tend to move similarly. This suggests a common factor like overall market investor sentiment rather than individual fund issues.

Puzzle 4: Why do prices converge to NAV at termination? (Liquidation)

When funds liquidate or convert to open-end, market prices remarkably converge exactly to NAV. If discounts were due to hidden liabilities like future fees or taxes, NAV should fall at liquidation. Instead, market prices rise to NAV, proving the initial market price was ‘wrong’ from the start.

4. Puzzle Explanation: Rational Markets vs. Human Psychology

How can we explain these puzzles?

Limits of Traditional Financial Theory

Traditional economics cites management fees, taxes, and illiquid assets as causes but fails to explain the extreme discount volatility (Puzzle 3) or price convergence at liquidation (Puzzle 4).

Behavioral Economics Solution: Investor Sentiment Hypothesis

The most convincing explanation is the Investor Sentiment Hypothesis.

• Core idea: Closed-end funds are mainly held by individual investors, or ’noise traders.’ Their collective sentiment (pessimism/optimism) drives discount rates.
• Limits to Arbitrage: Why can’t rational investors (smart money) correct these pricing errors? Because of noise trader risk. Even if they buy discounted funds today, tomorrow’s more pessimistic noise trader sentiment could push prices lower. This risk means arbitrage is not risk-free, allowing price discrepancies to persist.

This hypothesis explains all four puzzles:

1. (Premium): Temporary optimism from IPO marketing
2. (Discount): Baseline pessimism of individual investors and limits to arbitrage
3. (Co-movement): Waves of investor sentiment sweeping the entire market
4. (Convergence): Noise trader risk disappears at liquidation, enabling risk-free arbitrage

5. Empirical Case: The Korea Fund (KF)

Let’s verify with real data from a representative closed-end fund investing in the Korean market, the ‘Korea Fund (KF).’

Table 2: Korea Fund (KF) Discount Rates (as of July 25, 2025)

As shown, KF consistently trades at an average discount around -15% (Puzzle 2), with discount volatility exceeding 10 percentage points within a year (Puzzle 3). This reflects the dynamic shifts in foreign individual investor sentiment toward the Korean market.

Conclusion

The closed-end fund puzzle provides strong evidence that markets are not always rational or efficient. Asset prices reflect not only intrinsic value but also the collective psychology of market participants.

• Key Takeaways

  1. Law of One Price is an ideal: Investor psychology can easily break it in real markets.
  2. Closed-end fund structure matters: No redemption allows price-value divergence.
  3. Psychology drives prices: Noise trader risk and limits to arbitrage prevent rational investors from correcting mispricing, making investor sentiment a major price driver.

• Call to Action If this article helped you understand market irrationality, consider reviewing your investment portfolio. Deeply discounted closed-end funds may offer opportunities, but remember the unpredictable risk of ‘investor psychology’ lurking beneath.