Open-End Organizational Structures and Limits to Arbitrage

Abstract

We provide evidence that open-end structures undermine asset managers' incentives to attack long-term mispricing. First, we compare open-end funds with closed-end funds. Closed-end funds purchase more underpriced stocks than open-end funds, especially if the stocks involve high arbitrage risk. We then show that hedge funds with high share restrictions, having a lower degree of open-ending, also trade against long-term mispricing to a larger extent than other hedge funds. Our analysis suggests that open-end organizational structures are not conducive to long-term risky arbitrage.

An empirical examination of the diversification benefits of U.K. international equity closed-end funds

“…Due to the performance-flow relation in OEF, fund managers are likely to avoid long-term mispricing opportunities (Shleifer and Vishny(1997), Stein(2005)). Giannetti and Kahraman(2017) find that U.S. CEF are much more likely than OEF to trade in fire sale stocks (especially small stocks and stocks with high idiosyncratic risk) and at times when aggregate noise trader demand is low for certain undervalued stocks. Giannetti and Kahraman find that CEF significantly outperform OEF using Net Asset Value (NAV) returns 4 .…”

Illiquidity in Intermediate Portfolios: Evidence from Large Hedge Funds

“…Our finding that investor share illiquidity delivers greater risk-adjusted returns than portfolio illiquidity is not particularly surprising. In addition to matching the illiquidity of assets and liabilities, previous research has found that tighter share restrictions may facilitate higher returns through greater managerial discretion (Agarwal, Daniel, and Naik (2009)), through the ability to exploit opportunistic trading opportunities during times of market stress and tight funding conditions (Shleifer and Vishny (1997), Aragon, Martin, and Shi (2019)), or through profitable trades with uncertain payoff horizons (Giannetti and Kahraman (2017)). Thus, we should expect the excess returns associated with tighter share restrictions to comprise both the illiquidity premium earned on funds' illiquid assets as well as additional returns that arise from greater trading flexibility and discretion.…”

“…Similarly, an additional log-day of investor share illiquidity produces an excess return of 76 basis points per year. This suggests share restrictions may provide economic value to investors beyond matching the illiquidity of assets and liabilities, such as greater managerial discretion (Agarwal, Daniel, and Naik (2009)), an ability to exploit opportunistic trading opportunities during times of market stress and tight funding conditions (Shleifer and Vishny (1997), Aragon, Martin, and Shi (2019)), or to pursue profitable trades with uncertain payoff horizons (Giannetti and Kahraman (2017)). Or, it may be that the measure of average portfolio illiquidity we use fails to account for the entirety of illiquidity exposure, and tighter share restrictions better proxy for such exposure.…”

Bank-Intermediated Arbitrage

“…Our paper differs from this prior literature by showing that leverage provision by prime brokers to their clients may limit the ability of arbitrageurs to correct mispricing even outside of crisis periods. Finally, Giannetti and Kahraman (2017) and Franzoni and Giannetti (2017) study the trading behavior of funds with different funding structures. Giannetti and Kahraman (2017) show that open-end funds, which are more subject to limits-to-arbitrage frictions, are less likely to purchase underpriced stocks than closed-end funds.…”

“…Finally, Giannetti and Kahraman (2017) and Franzoni and Giannetti (2017) study the trading behavior of funds with different funding structures. Giannetti and Kahraman (2017) show that open-end funds, which are more subject to limits-to-arbitrage frictions, are less likely to purchase underpriced stocks than closed-end funds. Similarly, hedge funds with high share restrictions, having a lower degree of open-ending, also trade against long-term mispricing to a larger extent than other hedge funds.…”