Portfolio Performance, Discount Dynamics, and the Turnover of Closed-End Fund Mangers∗

Despite the large body of research on closed-end fund discounts, the existing literature has surprisingly little to say about how the labor market for closed-end fund managers works and to what extent fund managers are disciplined by the fund’s internal governance system. At the same time, research on the relation between closedend fund discounts and managerial performance generally ignores the possibility of internal governance actions such as manager replacement. This paper takes a step toward filling this gap by analyzing the relation between portfolio performance, discount dynamics, and manager turnover, using a database covering more than 400 funds in the U.S. from 1985 to 2002. We find that replaced managers underperform their peer groups prior to their replacement and that the fund performance improves after replacement. We also find that the 2-year lagged discount return is negatively related to the probability of manager replacement whereas the 1-year lagged discount return has no predictive power, which indicates that the change of discount not only contains information about managerial ability, but also reflects investors’ anticipation of the replacement of poorly performing managers. In the U.S. domestic fund sample, we also find that the anticipation of manager turnover changes the relation between discount return and NAV-performance. In the period in which the probability of manager replacement is remote, there is a positive relation between discount return and NAV return. However, this relation disappears in the period immediately before replacement. Overall, our results are consistent with the presence of an effective internal mechanism in disciplining closed-end fund managers, and support the view that fund discounts reflect investors’ rational expectations regarding both the fund manager’s ability and the fund management company’s future actions.