The adoption of a Managed Distribution Policy (MDP) by closed-end funds appears effective in dramatically reducing, even eliminating, fund discounts. We investigate various explanations: the signaling explanation offered in the literature - that the MDP serves as a positive signal of future fund performance - and alternatives based on agency problems and investor naivet? Our results indicate that signaling and agency are, at best, only part of the explanation. The evidence is more supportive of a naive investor hypothesis: the possibility that fund prices may be driven by naive investors that mistake payout - which can include return of capital - for performance. For funds adopting aggressive payout targets of 10% or larger, discounts tend to disappear or even be replaced by premia - though there is no discernible improvement in NAV performance. More moderate MDP funds experience a small reduction in discount and, under some specifications, an improvement in NAV performance. Consistent with investor naiveté aggressive MDP funds experience higher prices even when the payout involves a return of capital rather than profits. Institutions/large shareholders exert significant pressure for the adoption of aggressive payout policies. We find that institutions tend to build up their fund holdings prior to influencing the adoption of an aggressive MDP - and liquidate their positions, presumably selling to naive retail investors, once the price rises. While aggressive payout tends to deplete assets, funds that begin trading at a premium are able to replenish their capital, at least in part, through new rights offerings.
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