INSIGHTS

Link para o artigo original:https://www.acadian-asset.com/investment-insights/owenomics/stupidity-is-our-destiny-historic-closed-end-fund-overpricing

 

Are stock markets getting more efficient over time? Should we say that the arc of market history is long, but it bends towards rationality? Sadly, no. My own belief in market efficiency was shaken by the tech stock bubble, and took another gut punch in 2021 with meme stocks.

Today, the efficient market hypothesis faces a new adversary: the Destiny Tech100 fund (DXYZ).¹ I’ve previously criticized DXYZ for its approach to corporate naming. But that’s nothing compared to the market price of the fund.

On March 26th, DXYZ listed on NYSE as a closed-end fund with a net asset value (NAV) of $4.84. The price of DXYZ was $9 on the first day of trading, a pretty big premium but arguably within the realm of rationality given the difficult-to-value nature of the underlying assets: ownership claims in currently private companies such as SpaceX and OpenAI.

But over the next two weeks, the price of DXYZ rose, reaching a high of $105 on April 8th. Amazingly, DXYZ had a price that was 21X too high; the premium to NAV was more than 2,000%.

To the best of my knowledge, a premium of 2,000% is the highest premium ever observed in the eventful (outrageously dysfunctional? gloriously behavioral? quintessentially human?) history of closed-end funds in the United States over the past hundred years; I think the previous highest premium was 1,235% observed in 1929 according to DeLong and Shleifer (1991).²

What’s going on? Has the world gone mad? Is this ginormous premium a sign that the bubble apocalypse is upon us?

In this post, I discuss DXYZ and how it relates to research in financial economics in excess volatility, bubbles, and the Law of One Price (LOOP).

Here’s the big picture. First, DXYZ is a massive violation of LOOP. It fits in well with the general theme of LOOP violations: good story + retail investors + inability to arbitrage = LOOP violation. Second, while LOOP violations are indeed a symptom of market-wide bubbles, so far DXYZ appears to be an isolated incident. Last, DXYZ provides lessons about systematic equity signals such as short selling costs and issuance.

DXYZ is a valuation disaster but a marketing triumph. Like the meme stocks of January 2021, DXYZ offers retail investors a gripping populist narrative, a vehicle for their hopes and dreams, and a roller-coaster ride of exciting price action. DXYZ is a speculative stock: high volume, high volatility, and high valuation.

Closed-end fund mispricing reveals an important fact: sometimes the market goes haywire. It should not be hard to grasp that an NAV of $4.84 and a price of $105 are contradictory, yet somehow the market gets it wrong. Closed-end fund mispricings (like all LOOP violations) raise the following question, from Lamont and Thaler (2002): “If the market is flunking these no-brainers, what else is it getting wrong?”

The Law of One Price

The Law of One Price is arguably the most important idea in finance. Here’s Lamont and Thaler (2002):

The Law states that identical goods must have identical prices. For example, an ounce of gold should have the same price (expressed in U.S. dollars) in London as it does in Zurich, otherwise gold would flow from one city to the other …

Traditionally, economists thought that the Law could be applied almost exactly in financial markets because of the workings of arbitrage. Arbitrage, defined as the simultaneous buying and selling of the same security for two different prices, is perhaps the most crucial concept of modern finance. The absence of arbitrage opportunities is the basis of almost all modern financial theory, including option pricing and corporate capital structure. In capital markets, the Law says that identical securities (that is, securities with identical state-specific payoffs) must have identical prices; otherwise, smart investors could make unlimited profits by buying the cheap one and selling the expensive one.

The first sentence of Tolstoy’s Anna Karenina is “Happy families are all alike; every unhappy family is unhappy in its own way.” The same is true for LOOP: when LOOP holds, it holds straightforwardly; but every violation of LOOP is a violation in its own way. This makes LOOP violations an irksome topic involving many complex specifics.³ For closed-end funds, these specifics include expenses, fees, management actions, taxes, and liquidity; for a deep dive, peruse the references starting with Lee, Shleifer, and Thaler (1990).

Because DXYZ’s underlying assets are not liquid stocks with daily pricing, DXYZ’s premium is not a slam-dunk case against rationality. However, Lamont and Thaler (2002) review many other outrageous cases of LOOP violations where arbitrage fails to enforce proper pricing, and some of these (such as the Palm/3Com case) are as close to a slam-dunk as we’ll ever get.

Here’s Lamont and Thaler (2002):

Closed-end funds are a special sort of mutual fund that are interesting from the perspective of the law of one price … closed-end funds issue shares in the fund that trade in markets …

While closed-end fund discounts and premiums appear to be a violation of the law of one price, they might not be considered pure examples, since the two assets (the underlying securities owned by the fund and the fund itself) are not precisely identical … Nevertheless, these rational justifications for discounts and premia can at best justify small deviations between price of the fund’s shares and the value of the assets the fund owns.

… An extreme example is the Taiwan Fund trading on the New York Stock Exchange. During early 1987 (shortly after its start), it had a 205 percent premium, meaning that the price was more than three times the asset value (the premium stayed above 100 percent for ten weeks and above 50 percent for 30 weeks). This mispricing can persist due to legal barriers preventing U.S. investors from freely buying Taiwanese stocks. Still, the question remains why U.S. investors were willing to pay a dollar to buy less than 33 cents worth of assets.

Thaler and I were excited about the outrageously high 205% premium for the Taiwan fund. Little did we imagine that we’d later see a premium that was 10X bigger.

Funds: Open-end, closed-end, and exchange-traded

The Law of One Price does not always hold in finance because it is overruled by a different law: the law of supply and demand. Let me explain how different types of funds deal with changes in the demand for their shares.

Closed-end funds appeared in the U.S. in the 1890s and were the dominant form of U.S. investment trust in the early 20^th century. In a close-end fund, the quantity of shares is fixed (in the short-run), and thus price serves to equilibrate supply and demand. If demand is high, the fund may trade at a premium.

Open-end funds, introduced by the Massachusetts Investors Trust in 1924, are now the dominant investment vehicle for retail investors. In an open-end fund, supply of shares is not fixed, and inflows and outflows are transacted at the NAV of the fund. Supply, not price, is what equilibrates variation in demand.

Exchange-traded funds became popular after the introduction of SPY by State Street in 1993. ETFs have both flexible price and flexible supply, but the main equilibrating variable is supply, which moves to enforce LOOP. Every day, the supply of shares can grow or shrink. Thus, with rare exceptions, ETFs have tiny premia or discounts.

Enforcing LOOP through mechanically converting one security to another

LOOP is a great guide to pricing in many, many situations. It holds for ETFs because it is mechanically possible for authorized participants to create or redeem ETF shares. For ETFs, arbitrage is a piece of cake, and you don’t even need the ability to short sell.

Whenever it is mechanically possible for someone to convert one security into another (as is typically the case with ADRs and ETFs), LOOP should hold. In cases where it is not possible to convert one security to another (closed-end funds, China A vs. H shares, and certain dual-class shares such as GOOG vs. GOOGL), LOOP may be violated.

Now, there is one way in which we can mechanically convert from the NAV to the price for many closed-end funds: open-ending the fund. Let us suppose we have a closed-end fund with a price of $91 but an NAV of $100; this fund has a discount of 9%. That’s the current average discount on U.S. closed-end funds.⁴

If the fund converts from closed-end to open-end, it can eliminate the discount immediately, thus rewarding the shareholders with a 9% increase in value. Open-ending is feasible for closed-end funds that (unlike DXYZ) hold liquid, publicly traded stocks.

But fund companies rarely open-end, even when they have large discounts, because open-ending might result in the effective liquidation of the fund and the fund manager getting fired. It is for this reason that Benjamin Graham said discounts were “an expensive monument erected to the inertia and stupidity of stockholders” (Graham (1985)). Just imagine his thoughts on a 2,000% premium.

Enforcing LOOP by short selling

Another mechanism for enforcing LOOP is short selling. To execute a short sale, the short seller borrows shares from an existing owner and sells them to someone else. In this sense, short selling creates additional supply of shares, similar to authorized participants creating new ETF shares. So, you can think of short sellers as a substitute for the ability to mechanically convert securities; both actions have the economic result of increasing supply of shares available for purchase.

What might prevent short selling from enforcing LOOP?

• First, some investors are simply unable to short some stocks. I was shocked when, as a Ph.D. student in the early 1990s, I was unable to short closed-end funds because my broker said they were “unavailable.” Unavailable? I thought the stock market was a capitalist utopia where you could buy and sell whatever you want; not a Soviet-style system with shortages and forbidden transactions. I was mistaken. In order to short a stock, you need to borrow it, and because U.S. closed-end funds are not usually held by institutions that lend securities, they can be hard to borrow.
• Second, the fund may be expensive to short. When you borrow shares, you need to pay the lender a fee. This fee can be enormous, as we’ll see for DXYZ.
• Third, when you short, you face price risk. If the price is currently at $105 but the NAV is $5, what guarantee do you have that the price won’t double tomorrow? Thaler’s dictum: “The price seems stupidly high but could go up!” You could also call this “noise trader risk” or “sentiment risk,” but no matter what you call it, it’s not good.

 

These impediments to correcting mispricing fall into the general category of “limits to arbitrage” as described by Shleifer and Vishny (1997). For more details on shorting, see Daniel, Klos, and Rottke (2023).

The specifics of DXYZ

The narrative

Narratives are an important component of mispricing generally and LOOP violations specifically. Compelling stories include exciting new technology like hand-held computing in 2000, geopolitical events such as the fall of the Berlin Wall in 1990, and financial breakthroughs that supposedly democratize finance today.

DXYZ has a compelling story: it allows ordinary investors to join the elite circle who can own non-public companies like Stripe, SpaceX, and (the holiest of holies) OpenAI.

Here’s the idea:

It is a problem that has vexed retail investors for years, as start-ups like Stripe, SpaceX and OpenAI soar to enormous valuations in the private market. Only so-called accredited investors with a high net worth are allowed to invest in private tech start-ups. By the time the companies go public a decade or more after they started, their growth has often slowed and their valuations are high.

A new fund, Destiny Tech100, is trying to change that with a novel solution. It is offering a publicly traded fund that contains shares of 23 private tech companies including Stripe, SpaceX, OpenAI, Discord and Epic Games.⁵

The narrative here: “bring to the masses a class of investments that is usually off-limits to all but professional money managers and the rich.”⁶ Here is the indispensable Matt Levine:

It is a fascinating model: It trades publicly on the New York Stock Exchange (under the ticker DXYZ), but its investments are private and illiquid. It computes its net asset value quarterly, and its most recent computation lists its net asset value per share at $4.84. It went public last month with a reference price of $4.84, but started trading at $8.25 and went up from there; it closed on Friday at $59.20, and it was trading around $80 at noon today. It has a net asset value — its computation of the fair value of its underlying startup stakes — of about $54 million, and a market capitalization — the value that the market places on its shares — of about $875 million.

Somebody is wrong! One way to model this is that there is $875 million of demand from regular public investors to own shares in hot private startups, and so far only about $54 million of supply. But if each of this fund’s holdings goes up 1,000% by the time they go public, people who bought into the fund today will lose money. Weird!⁷

The valuation

The rational argument for DXYZ having a modest premium is that the fund is more liquid than the underlying assets (see Amihud, Mendelson, and Pedersen (2005)). But a 2,000% premium? No way.

The most commonly used adjective to describe DXYZ valuation is “insane:”

Bloomberg Intelligence: “It’s insane…Even if you assume the value of the underlying has quadrupled in three months (it almost certainly hasn’t), this is still trading at a crazy valuation.”⁸

Morningstar: Destiny Tech100′s massive premium represents a unique opportunity for investors to enrich others at the expense of themselves … DXYZ’s NAV premium is insane.⁹

Why buy DXYZ when you could buy something cheaper?

There are other ways to gain exposure to DXYZ’s underlying assets without paying a premium. One is an illiquid fund offered by ARK.¹⁰ Another is open-end funds:

Mutual funds at Fidelity, Baron Capital, and Neuberger Berman all own SpaceX—which accounts for 35% of Destiny Tech100’s assets … In those mutual funds, though, investors aren’t paying a huge NAV premium just to get a piece of SpaceX … an investor buying Baron Partners shares would effectively pay $97 per share for the SpaceX position, while a Destiny Tech100 investor would pay $864 for a share of SpaceX … ¹¹

Is the reported NAV too high?

One possible explanation for the observed premium is that while the reported NAV is $5, the true NAV is much higher. The evidence contradicts this explanation, because it is not clear that the assets owned by DXYZ are even legal:

Stripe has said that it forbids its current and former employees to strike such deals and that any forward contract is void. Mr. Prasad said his fund was confident the deals were legal.¹²

And NAV has been falling over time:

Destiny Tech100 started investing in 2021, the peak year of the pandemic tech boom, spending $77.4 million on its U.S. investments. As of December, those stakes were valued at $50.8 million, amounting to a loss of 34%, according to its annual shareholder report.¹³

Short selling costs

How expensive is shorting DXYZ? According to public data released by Interactive Brokers, the mid-April annualized cost is more than 100%. That’s extremely high.

How is it possible to have a cost that is more than 100%? The short selling fee is a daily amount that is paid by the borrower to the lender and is usually expressed as an annualized rate. Suppose the price is $105. If I pay the lender a fee of thirty cents per day, then expressed as an annual percent, I’m paying more than 100%. If I short, I only make money if the price falls more than thirty cents a day.

 

The closed-end fund debate

Empirical behavioral finance basically started with the fierce debate over closed-end funds taking place in the pages of the Journal of Finance in the early 1990s between Lee, Shleifer, and Thaler (LST) and Chen, Kan, and Miller (CKM).

Angry finance

This debate was an example of what the late Daniel Kahneman called “angry science:”

… the nasty world of critiques, replies, and rejoinders … Controversy is a terrible way to advance science. It’s normally conducted as a contest, where the aim is to embarrass—sarcasm for beginners …

… Doing angry science is a demeaning experience. I’ve always felt diminished by the sense of losing my objectivity when I get into the mode of scoring points in a debate. I hated it so much that I adopted a policy that Amos Tversky thought irresponsible: I do not respond to hostile papers.¹⁴

The debate started with Lee, Shleifer, and Thaler (1991):

… fluctuations in discounts of closed-end funds are driven by changes in individual investor sentiment … both closed-end funds and small stocks tend to be held by individual investors, and that the discounts on closed-end funds narrow when small stocks do well.

Chen, Kan, and Miller (1993a) followed:

Killing two such elusive birds with one stone would be a neat trick if Lee at al could bring it off. But they can’t ….

Chopra, Lee, Shleifer, and Thaler (1993a) responded:

Chen, Kan and Miller (1993, best pronounced CheK’M) provide a detailed critique of our earlier paper (Lee, Shleifer, and Thaler (1991)). CKM accuse Lee et al of trying to kill two birds—the close-end fund puzzle and the small firm effect—with one stone and missing both. Their approach is to throw at Lee et al every stone they can, presumably hoping that one will hit. This reply shows that none does.

I’ll stop there, but the authors continued in the same vein in Chen, Kan, and Miller (1993b) and Chopra, Lee, Shleifer, and Thaler (1993b).

Two comments. First, although Thaler was a disciple of Kahneman, he ignored Kahneman’s high-minded policy and instead engaged in angry science. But this strategy paid off, according to Thaler (2015):

I don’t know who won, but I do know that the unprecedented four-part pissing contest about our paper attracted a lot of attention.

Second, this unseemly academic “pissing contest” was about discounts/premia of at most 50%. They were arguing over small LOOP violations compared to the 2,000% violation in DXYZ. I’m not sure what would be the rational story for a 2,000% premium, but I have confidence in the Fundamental Law of Active Theorizing™: Sufficiently motivated theorists can devise a theory to produce any desired result.

There was much research about closed-end funds in the 1990s and early 2000s. When Baker and Wurgler (2006) constructed their sentiment index, they thought closed-end fund discounts were important enough to be included.

But over the years, academic interest waned. More compelling violations of LOOP arose, as documented by Lamont and Thaler (2002) and subsequent work. And while the big ideas proposed by LST were right (LOOP violations reveal mispricing, sentiment impacts the aggregate stock market), the specifics didn’t pan out. Closed-end fund discounts did not turn out to be a good generic sentiment index, failing to reflect investor sentiment during the tech stock bubble, for example.

Meanwhile, the closed-end funds themselves continue to produce bizarre pricing puzzles. Let me mention two: bond funds and CUBA.

Bond funds

Over the past 10 years we’ve seen premia on the order of 50% to 100% for a small number of closed-end bond funds (managed by PIMCO and Gabelli). For example, consider Gabelli funds in 2016:

The Gabelli Utility Trust commands a premium of about 21.9%, and a new fund, Gabelli Go Anywhere Trust Combo, trades at a premium of more than 45%.

“Big premiums make no sense and big discounts make no sense,” says Mario Gabelli, chairman and chief executive of Gamco Investors Inc., which runs the funds. “That Go Anywhere fund should not sell at that premium. We are advising people not to buy it…It is important to remember that ’Mr. Market’ is a pendulum that swings both ways. As the market moves away from momentum investing and back to basics, we believe that a high premium for the fund is not likely to be sustainable.”¹⁵

It’s amazing to hear a fund manager advising clients not to buy his product. Admittedly, there’s no danger of client withdrawals for closed-end funds, but I’m still impressed. Bravo, Mario.

Gabelli said the premium was not “sustainable” and the pendulum would swing “back to basics.” The pendulum swung all right, but in the wrong direction. As of mid-April 2024, the Gabelli Utility Trust has a premium around 100% (up from 22% in 2016). Lesson: crazy mispricing can last many years. We see this in the China AH premium as well, with very high premia for individual stocks persisting for decades.

The CUBA fund

Another case is the CUBA fund in 2014 described in Thaler (2016):

The particular fund I want to highlight here happens to have the ticker symbol CUBA. Founded in 1994, its official name is the Herzfeld Caribbean Basin Fund, which has 69 percent of its holdings in U.S. stocks with the rest in foreign stocks, chiefly Mexican. It gave itself the ticker “CUBA” despite the fact that it owns no Cuban securities nor has it been legal for any U.S. company to do business in Cuba since 1960 (although that may change at some point). The legal proviso, plus the fact that there are no traded securities in Cuba, means that the fund has no financial interest in the country with which it shares a name. Historically, the CUBA fund traded at a 10–15 percent discount to Net Asset Value. 

Figure 1 plots both the share price and net asset value for the CUBA fund for a time period beginning in September 2014. For the first few months we can see that the share price is trading in the normal 10–15 percent discount range. Then something abruptly happens on December 18, 2014. Although the net asset value of the fund barely moves, the price of the shares jumped to a 70 percent premium. Whereas it had previously been possible to buy $100 worth of Caribbean assets for just $90, the next day those assets cost $170! As readers have probably guessed, this price jump coincided with President Obama’s announcement of his intention to relax the United States’ diplomatic relations with Cuba. Although the value of the assets in the fund remained stable, the substantial premium lasted for several months, finally disappearing about a year later. 

The investment thesis here makes absolutely zero sense, and the CUBA fund is arguably the most inherently idiotic mispricing in the history of finance (and, like DXYZ, reflects brilliant marketing by the fund company). In contrast, DXYZ is based on a rational idea and is not inherently idiotic. However, the CUBA fund had only a 70% premium, small potatoes compared to DXYZ.

LOOP violations and bubbles

Historically, bubbles have created LOOP violations. Mackay (1841) describes the South Sea Bubble of 1720:

So great was the confusion of the crowd in the alley, that shares in the same bubble were known to have been sold at the same instant ten per cent higher at one end of the alley than at the other.

Similarly, many of the cases in Lamont and Thaler (2002) come from the tech stock bubble. While that bubble did not manifest in closed-end fund premia, the 1929 bubble did. DeLong and Shleifer (1991) found median premiums rise to 50% in late 1929.

Aggregate issuance is one of my four horsemen of the bubble apocalypse, with high issuance indicating that equity is overpriced. Here’s DeLong and Shleifer (1991) describing the wave of closed-end fund issuance in 1929:

new closed-end fund issues in the third quarter of 1929 reached their highest level ever … both high premia and large volumes of new closed-end fund issues are evidence of excessive investor optimism.

… closed-end funds will be issued when investors are excessively bullish, as entrepreneurs attempt to profit from this excessive bullishness by repackaging stocks into funds. After the crash, investigators asked Goldman Sachs partner Sydney Weinberg why his company had formed so many closed-end funds so rapidly in 1929. He replied, “Well, the people want them.”

“Well, the people want them.” Classic. Note the contrast with Gabelli.

Now, to be clear, issuance by closed-end funds is not the same as issuance by underlying firms. But in 1929, closed-end funds were the dominant vehicle for retail investors, similar to open-end funds in 1999. Both in 1929 and 1999, underlying firms issued equity that was sold to retail investors via mutual funds.

So, does the mispricing of DXYZ tell us we are in a 1929-like bubble? I don’t think so, not yet. For example, the CUBA fund was a one-off; it did not signal a wider bubble in U.S. stocks in 2014. Here’s what would get me worried:

• We see other LOOP violations where security of type A is overpriced relative to type B.
• We see a wave of issuance of securities of type A.
• The whole U.S. equity market looks expensive because securities of type A are expensive.

In coming months, we may see a wave of issuance from DXYZ imitators. When the Berlin Wall fell, we saw a similar wave of new Germany-focused country funds exploiting the overpricing of the Germany Fund (see Klibanoff, Lamont, and Wizman (1998)). This issuance was confined to the narrow area of country funds and did not have wider implications for the whole market in 1990.

Excess volatility, value, and “volatility soiling”

An important idea in finance is “excess volatility:” market prices move too much relative to fundamentals, as in Shiller (2014). In the case of closed-end funds, prices are more volatile than the NAV as shown in Pontiff (1997), suggesting that packaging already risky assets into tradeable vehicles somehow adds another layer of risk.

Both for the aggregate stock market and for closed-end funds, excess volatility implies predictable returns. For closed-end funds, when NAV and prices disagree, it is mostly price that is wrong and NAV that is right (Pontiff (1995)).

So, the most obvious lesson from closed-end funds is this: value can be a profitable trading signal. Even if we don’t get mean-reversion (the “pendulum” mentioned by Gabelli), cheap assets will still generate higher returns due to higher cash distributions to shareholders.

Can we say more about volatility? DXYZ is extremely volatile, going from $9 to $105 and then back down to $27 in its first month of trading. Is this volatility a feature or a bug?

Let me offer a conjecture. Traditionally, private equity was the domain of institutional investors who desire low risk and no drawdowns. Cliff Asness coined the term “volatility laundering”¹⁶ to describe the seemingly smooth returns reported by private equity funds. In contrast, DXYZ is presumably owned by retail investors who prefer high upside (lottery-loving speculators want to buy risky assets, not boring safe assets). DXYZ’s strategy of repackaging illiquid assets into a highly volatile fund could be called “volatility soiling.” Unlike volatility laundering, volatility soiling is not about hiding risk but is about adding additional risk where none previously existed.

Volatility laundering for risk-hating institutional investors, volatility soiling for risk-loving retail investors. Everybody wins!

The next logical step in volatility soiling would be a new closed-end fund (call it DDXYZ) that only holds DXYZ, followed by the creation of DDDXYZ that holds only DDXYZ, and so on. I know it sounds absurd, but it’s happened before. Here’s Delong and Shleifer (1991) describing the largest closed-end fund in 1929, the Goldman Sachs Trading Corporation:

In 1929 one of its largest holdings was the Shenandoah Corporation, another closed-end fund organized by Goldman Sachs. Another large holding was in its own stock. Nor is this all. In the same year, Shenandoah organized a new closed-end fund called the Blue Ridge Corporation and became a large investor in its stock. All these funds traded at premia; at the top of the pyramid, the Goldman Sachs Trading Corporation traded at a premium to a premium to a premium to net asset value… It is hard to justify these pyramided financial structures as anything other than an attempt to part fools from their money by capitalizing on layer upon layer of investor overvaluation.

Most of these shenanigans were outlawed by the Investment Company Act of 1940.

Systematic equity investing: Lessons from DXYZ

Most stocks do not come with a little label that tells you what the fundamental value is. DXYZ does, and so we can tell that DXYZ was enormously overpriced. So, to the extent that other stocks resemble DXYZ, we can infer that these other stocks are also overpriced.

Speculative stocks

The unholy trinity:

This unholy trinity of high valuation, high volume, and high volatility is always bad news… a “speculative stock” is a stock that has all three of the Vs, and on average they have low subsequent returns.

We’ve already talked about valuation and volatility. What about volume? At its peak on April 8, DXYZ had daily turnover of 80% and thus an average holding period of 1.2 days. You could argue that investors don’t care about overvaluation if they are only holding DXYZ for 1.2 days.

Issuance

Issuance is not just an aggregate bubble indicator, it also works for individual stocks. For example, Daniel, Hirshleifer, and Sun (2020) use issuance to measure long-term mispricing:

… issuance/repurchase activity is a catchall for many possible sources of “stubborn” investor misperceptions …

Firms are smart money, and sell (issue) equity when it is overpriced.

What is DXYZ doing? In mid-April, DXYZ announced plans to issue up to $1B of equity (for comparison, current AUM is $54M).¹⁷

Short selling costs

Stocks with high shorting costs have low subsequent returns (Jones and Lamont (2002)). Engelberg et al (2022) found that costs are “the best predictor” of stock returns out of 102 possible signals. Lamont and Thaler (2003) found high shorting costs in the Palm/3Com case, another notable LOOP violation.

DXYZ had very high shorting costs, above 100%. That means that there existed well-informed arbitrageurs who were willing to gamble that DXYZ would fall by more than (annualized) 100% per day. That’s big.

Conclusion: The perfect storm of overvaluation

Here are the top items on my checklist for the Platonic ideal of an overpriced stock. First, the price is far above a super-accurate measure of fundamental value. Second, the company is issuing shares. Third, many traders would like to short the stock, but it is expensive or impossible to short. Fourth, the stock is speculative with high risk and high trading volume. Fifth, the stock has a compelling story that appeals to the type of retail investor who is unaware that closed-end funds have an NAV.

DXYZ checks all the items on my checklist.

Closed-end funds are a minor part of U.S. capital markets, and the mispricing of DXYZ is a quantitatively small event in the grand scheme of things. But while relatively small in dollar terms, closed-end fund mispricing can be big in terms of what it reveals.

We learn the following. There are some crazy investors out there. They are impacting prices. And we can use a checklist of specific signals to detect mispricing, not just in closed-end funds, but across all stocks.

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References

Amihud, Yakov, Haim Mendelson, and Lasse Heje Pedersen. “Liquidity and asset prices.” Foundations and Trends in Finance 1, no. 4 (2006): 269-364.

Baker, Malcolm, and Jeffrey Wurgler. “Investor sentiment and the cross‐section of stock returns.” The Journal of Finance 61, no. 4 (2006): 1645-1680.

Chen, Nai-Fu, Raymond Kan, and Merton H. Miller. “Are the discounts on closed-end funds a sentiment index?.” The Journal of Finance 48, no. 2 (1993a): 795-800.

Chen, Nai-Fu, Raymond Kan, and Merton H. Miller. “A Rejoinder.” Journal of Finance 48, no. 2 (1993b).

Chopra, Navin, Charles MC Lee, Andrei Shleifer, and Richard H. Thaler. “Yes, discounts on closed-end funds are a sentiment index.” Journal of Finance (1993a): 801-808.

Chopra, Navin, Charles Lee, Andrei Shleifer, and Richard H. Thaler. “Summing Up.” Journal of Finance 48, no. 2 (1993b).

Daniel, Kent, David Hirshleifer, and Lin Sun. “Short-and long-horizon behavioral factors.” The review of financial studies 33, no. 4 (2020): 1673-1736.

Daniel, Kent D., Alexander Klos, and Simon Rottke. “Optimists, pessimists and stock prices.” 2023.

DeLong, J. Bradford, and Andrei Shleifer. “The stock market bubble of 1929: evidence from closed-end mutual funds.” The Journal of Economic History 51.3 (1991): 675-700.

Engelberg, Joseph, Richard B. Evans, Gregory Leonard, Adam V. Reed, and Matthew C. Ringgenberg. “The loan fee anomaly: A short seller’s best ideas.” 2022

Glaeser, Edward L., and Charles G. Nathanson. “An extrapolative model of house price dynamics.” Journal of Financial Economics 126, no. 1 (2017): 147-170.

Graham, Benjamin. The Intelligent Investor. New York: Harper & Row, 1985.

Jones, Charles M., and Owen A. Lamont. “Short-sale constraints and stock returns.” Journal of Financial Economics 66.2-3 (2002): 207-239.

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