Sentiment and the Interpretation of News about Fundamentals

The reaction of closed-end fund share prices to changes in portfolio values is on average the same whether funds are trading at discounts or premia and whether the changes in portfolio values are positive or negative. If closed-end fund discounts and premia do correctly measure investor sentiment, then these results suggest that investor sentiment does not affect the market’s reaction to news about fundamentals. Alternatively, discounts and premia may not in fact measure investor sentiment, or sentiment may play no role at all in closed-end fund pricing. Noise-trader risk and trading costs also fail to explain the observed behavior. ∗Department of Economics, Vassar College, 124 Raymond Ave. #424, Poughkeepsie, NY 12604. [email protected] I would like to thank Osaka University’s Institute for Social and Economic Research for their support while I worked on this paper. I also gratefully acknowledge the sedulous research assistance of Doug Park. All errors are my own. Vassar College Economics Working Paper # 72 This paper examines closed-end funds to see whether investor sentiment affects the market’s reaction to news about fundamentals. Closed-end funds are the perfect vehicle for this inquiry for three reasons. First, their shares trade on major stock exchanges exactly like the shares of operating companies (Dimson and Minio-Kozerski 1999). Second, they publish their portfolio values weekly, meaning that there is very little uncertainty about the fundamental valuations of closed-end funds or about how those valuations change over time (Lee, Shleifer, and Thaler 1990). Third, the fact that they typically trade at discounts or premia to their portfolio values gives a natural metric for investor sentiment: funds trading at discounts are funds about which investors are pessimistic, while funds trading at premia are funds about which investors are optimistic (Chopra, Lee, Shleifer, and Thaler 1993). To examine whether investor sentiment affects the interpretation of news about fundamentals, I examine how closed-end fund share prices react to changes in fund portfolio values when conditioning on discount and premium levels. In addition, I look separately at increases and decreases in portfolio values in order to check whether the state of sentiment colors the market’s reaction to positive and negative news. I find that the reaction of closed-end fund share prices to changes in portfolio values is on average the same whether portfolio values increase or decrease and regardless of the discount or premium level at which a fund is trading. This behavior is confirmed by examining a comprehensive data set containing nearly every US and Canadian closed-end fund trading between 1985 and 2001. Using this data set, I first sort all changes in portfolio values into positive and negative changes. I do this because if sentiment affects the reaction of share prices to changes in portfolio values, sentimental investors might react differently to good and bad news—i.e. to positive and negative changes in portfolio values. I then sort the observations in each group by their associated discount and premium levels. I do this because you might expect optimistic and pessimistic investors to react very differently to changes in portfolio values. Once these sorts are made, I account for the fact that discounts and premia tend to slowly mean revert towards rational valuations. This tendency means that prices tend to drift towards portfolio values