Fair value's effects on closed-end funds' discounts and premia: is level 3 the sole perpetrator?

Abstract

PurposeThis study examines the long-term link between fair valuation uncertainty and discounts/premia in closed-end funds. This study argues that, in exploring the close-end funds puzzle, prior research generally omits to consider the uncertainty surrounding the measurement of funds' financial disclosure, as reflected in the fair value hierarchy, when investment specialty differs across funds.Design/methodology/approachRegressions were employed to explore how the fair value hierarchy affects closed-end funds' discounts/premia when investment specialty differs. The authors also examine the effects pre- and post-2012 to explore if that relationship changes due to the additional disclosure requirements enacted at the end of 2011.FindingsThe authors find that the three levels of the fair value hierarchy have effects that vary according to a fund's specialty. For equity specialized funds, Level 3 significantly increases discounts and decreases premia, suggesting the impact of valuation uncertainty that underlies Level 3 estimates; this relationship disappears (decreases in severity) for premia (discount) experiencing funds post-2012. In contrast, Level 1 and Level 2 do not have any significant effect on discounts or premia except that post-2012, Level 2 begins to display discount decreasing effects. For bond specialized funds, no significant association was noted between premia and any of the fair value levels except that post-2012, Level 3 begins to display premium increasing effects. However, results are different for discounts. The authors note that Level 1 valuations significantly increase discounts, but only post-2012; Level 2 valuations significantly decrease discounts (pre- and post-2012), consistent with such estimates incorporating unique and relevant information; and Level 3 valuations do not have a significant effect on discounts.Originality/valueThe results of this study revisit prior evidence and indicate that results about the effects of fair value measurement and the closed-end funds' puzzle are sensitive to the period length being considered and the investment specialty of the fund. The authors also note that additional disclosure regarding Level 3 valuation inputs decreases market concern for valuation uncertainty and increases the liquidity benefits of investing in Level 3 carrying funds.

Re‐exploring Fair Value Accounting and Value Relevance: An Examination of Underlying Securities

“…Lawrence et al (2013) also support the subjectivity/private information argument when they note that Level 3 fair values are more informative of securities' future cash flows and more predictive of future stock returns than Level 1 and Level 2 fair values. And while Cullinan and Zheng (2014) note the discounting of closed-end funds' market values due to the presence of investor uncertainty towards Level 3 fair valuations, with no discounting due to either Level 1 or Level 2, Fortin et al (2020) note that the discounting of closed-end funds could be caused by other fair value levels as well, such as Level 1 securities in bond specialized funds. These findings clearly illustrate the lack of consensus regarding fair value levels' value relevance and the lack of consensus regarding uncertainty in those levels.…”

“…Second, our paper provides empirical evidence that different bonds are not all equal in their impact on market values, as Level 2 corporate and municipal bonds' fair value estimates exhibit higher value relevance than those of Level 2 government bonds, thereby showing that a general category for the type of investment (e.g., equities versus bonds in general) is not sufficient to empirically capture the intrinsic nature of investments. Hence, we expand on the results of Fortin et al (2020), who show that a fund's specialty in either equity or bonds has an impact on whether that fund experiences a discount or a premium. Third, we contribute to the audit literature by showing that the benefits of auditing in terms of enhancing the value relevance of fair value estimates arise mostly from certain types of securities, for which fair value estimates can be deemed to rely on more sophisticated models and which embed greater risks, that is, equities and corporate bonds (versus municipal or government bonds).…”