Excess Discount Return. A Comparative Study of UK Investment Trusts and US Closed-End Funds

In this article, we extend the three-factor of Fama and French’s (1993) model in order to explain the existence and persistence of the excess discount return. We added two more factors to these four risk measures namely market, size, book-to-market, and momentum. The first one is based on the results of Lee, Shleifer and Thaler (1991) that closed-end funds are subject to systematic investor sentiment risk. We measure this sentiment in two ways as the changes in retail flows and investor sentiment index. This sentiment measure excludes the funds during their first six month of trading. The reason is to eliminate the influence of premiums that correspond to underwriting fees and start-up costs. The expense ratio can be proxied monthly as percentage of total assets. These include the annual management charge or staff costs, auditors and custody fees, directors fees and marketing costs. On average the six factor model can explain 67% of the variation in the excess discount return in the UK market by taking into consideration market, size, book-to-market effect, momentum, sentiment and expenses. In contrast, Fama and French (1993) three factor and four factor model can explain 42% of the variation of the excess discount return. On the other hand, on average the six-factor model can explain 66 % of the variation of the excess discount returns in the US market. In contrast, Fama and French (1993), three-factor model can explain 59% of the excess discount return variation and Carhart’s (1997) four factor model can explain 65% of the variation