A Rational Model of the Closed-End Fund Discount1

The discount on closed-end funds is widely accepted as proof of investor irrationality. We show, to the contrary, that a very simple parsimonious rational model can generate a discount that exhibits the behavior observed in practice. The only required features of the model are that managers have (imperfectly observable) ability to generate excess returns; they sign long-term contracts guaranteeing them a fee each year equal to a fixed fraction of assets under management; and they can leave to earn more money elsewhere if they turn out to be good. With these assumptions, time-varying discounts are not an anomaly in a rational world with competitive investors – they are required. JEL classification: G14. Address mail correspondence to either author at Haas School of Business, University of California, Berkeley, CA, 94720-1900, or electronic correspondence either author’s email address: [email protected] (Berk) or [email protected] (Stanton).