What Really Drives the Closed-End Hedge Fund Discount?

A couple of weeks ago, we examined the “rational irrationality” in the way that closed-end hedge funds are traded. While you’d expect a flood of new hedge funds listings during periods when secondary market discounts were low, that was not always the case. In fact, a lot of hedge funds IPO’d closed end funds during recent rough spots for the industry.

Our friends at Opalesque reported recently from Monaco where Tarun Ramadorai of Oxford University was discussing his research into the field of closed end hedge funds. Regular readers may remember Ramadorai from a post we published last spring on secondary market pricing data from HedgeBay.

At the time, we only discussed the endogenous factors that went into determining hedge fund discounts - recent performance, historical volatility, portfolio liquidity etc. But there was one important exogenous factor that helps explain both closed end hedge fund and closed end mutual fund pricing: interest rates.

As this chart from Ramadorai’s 2008 paper clearly illustrates, discounts fall (premiums rise) when interest rates are down. (black and green = closed end HF premium, blue = 3 month T-Bill rate, both on a scaled vertical axis)

It looks like investors in closed end hedge funds aren’t the only ones who get excited by low rates. Check out the correlation between the premium on closed end hedge funds (black) and the premium on closed end mutual funds (red).

Two weeks ago we learned that the volume of new capital raised by a hedge fund was dependent on manager-specific factors. That suggested that demand was influenced by manager-specific factors.

In fact, according to Opalesque, Ramadorai also “…believes that the secondary market can be used as an indicator of what hedge fund investors are thinking when they enter and exit hedge funds.”

But in retrospect, Ramadorai’s research seems to suggest the contrary - that closed end HF premia/discounts are influenced more by interest rates and the broader market for closed end funds than on the specific fund’s characteristics. In other words, “what hedge fund investors are thinking when the enter or exit hedge funds” appears not to be that complex.

Comments

[Joe Eqcome:]

Christopher

What is the universe of closed end hedge funds being analyzed?
Is it a group of publicly traded closed end funds or is it a universe of private hedge funds where someone independently valuing the premium/discount?
A hyperlink to a source document would be much appreciated.
Sorry, I'm a pilgrim in this land.

Joe Eqcome

Jul 06 11:59 AM

[ETFdesk.com:]

Hi Christopher, you bring up an interesting point. It would be good to get other closed-end investors take on it. I would also strongly consider the VIX as well as season trends (i.e. tax loss selling). Additionally, given the closed-end funds ability to use leverage at rates cheaper than a normal investor, the steepness of the yield curve is also a contributing factor...

Jul 06 10:44 PM

[Avooch:]

The discount is there because investors don't like to pay high fees to snake oil salesmen.

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Aug 06 09:29 AM