comparative valuation process and performance of single-country closed-end funds, The

Multinational Business Review, Spring 1994 by Abdullah, Fuad A, Medewitz, Jeanette N, Olson, Keith A

Single-country closed-end funds represent a recent and largely untested vehicle for international portfolio diversification. Nevertheless, investments in such funds by U.S. institutional and individual investors was estimated at $4.09 billion at the end of 1989 (Dryden 1990). Although a Japan Fund was established in 1962,(1) no other fund was traded on the exchanges until the Mexico Fund was listed on the NYSE in 1981, followed by the Korea Fund in 1984. More recently, the First Germany Fund, which commenced trading on the NYSE in mid-1986, as well as other Germany funds, attracted a great deal of investment attention fueled by the unification of Germany, and the opening up of the markets of East European countries. Most single-country funds initially trade at a premium above their net asset value (NAV). However, as the original expectations have proven too optimistic, the premia have tended to dwindle, and have often been replaced by substantial discounts.

A closed-end country fund stock is essentially a prorated share in a diversified portfolio of equity investments in the country after which the fund is named. It represents an alternative and indirect medium of investing in foreign equity markets. In effect, a share in a country fund trading in the United States represents an American Depository Receipt of a foreign closed-end investment company. As such, the fortunes of this instrument are tied not only to the NAV of the underlying portfolio, but also overall equity market performance in the country of trading, as well as both exchange and political risks.

Although there is ample trade literature on the merits and performance of single-country funds, academic interest into the dynamics of this novel instrument and the variables underlying the determination of its market price have only recently developed. Most of the trade literature focused on the speculative nature and volatility of single-country closed-end funds (Carey 1987; Kare and Frohlich 1991).

Recent inquires have focused on the determinants of the premiums and discounts on closed-end country funds in relation to the NAV. Bonser-Neal et al. tested whether announcement of changes in investment restrictions affect changes in the premiums and discounts on closed-end country funds. They cross-correlated changes in the price of 16 closed country funds with changes in their NAV, using weekly data from May 1981 to January 1989. They concluded that, keeping all else constant, investment restrictions, such as government imposed barriers, will raise a country fund's price relative to its NAV by "approximately the amount the marginal domestic (U.S.) investor will pay to circumvent these restrictions'(Bonser-Neal et al., 1990). They also argued that fund premia can vary through time even in the absence of changes in investment restrictions.

Cumby and Glen(1990) examined the performance of a sample U.S.-based international diversified mutual funds for the period January 1982 to June 1988. Using primarily Jensen's test as a measure of performance, they concluded that there was no evidence that these funds, either individually or as a whole, provide investors with performances that surpass the returns provided by a broad, international equity index over the same period.

Premiums on country funds in their initial public offerings (IPOs) are analogous to a sales charge or a load on a mutual fund. However, they are viewed by some investment advisors as speculative premiums engendered by the initial strong market demand and the exaggerated return expectations (Olin 1990). Anderson and Born (1991) suggested that most country funds yield positive returns to investors shortly following the IPOs. However, most of the funds experienced substantial erosion in their relative premiums in the twenty weeks following the IPOs. They also found no meaningful correlation between changes in prices of these funds and changes in their NAVs. They concluded that the independence of returns to shareholders from returns on the underlying country's portfolio reduces the diversification value of single country funds to U.S.-based investors.

HYPOTHESIS

This paper examines the market valuation process of closed-end single-country funds by identifying the underlying determinants of changes in share prices and NAVs. We will investigate the relationships among these changes and the performance of a broad equity index of the underlying portfolio (the foreign country) and the domestic country (the country where these funds are traded). For the purpose of this study, the domestic country will be the United States.

Cumby and Glen (1990) and similar studies in the finance literature compared the returns from diversified mutual funds with those of benchmark portfolios or indexes, such as the S&P 500 or Morgan Stanley World Index. Unlike these investigations, this paper focuses on the underlying vehicles during the valuation or pricing process of closed-end country funds.

Specifically, we will test the hypothesis that changes in the prices of closed-end single-country funds shares and their NAVs are primarily driven by the performance of an equity index in the underlying portfolio country. Investors who buy shares in these funds act on a priori' belief that such relationships exist. Empirical data, however, suggest that the performance of a broad equity index in the country of trading may also be a factor in the valuation process. We will attempt to determine to what extent, if any, the performance of equities in the domestic country is a significant variable in the pricing of this instrument.