An Evaluation of ICAP’s Performance and Determinants of its Discount

ICAP — NAV Return, Price Return and Premium/Discount

• Blue Line: reflects the fund manager’s skill in portfolio management and overall investment strategy. A rising NAV-based return can indicate an ability to identify profitable investment opportunities.
• Green Line: Represents investor return, and is influenced by the intrinsic performance of the fund (NAV) and several other factors that can cause fund’s shares to trade at a premium or discount to its NAV–is not purely indicative of the fund manager’s skill.

Academic Explanations for CEF Discounts

• Luck of Management Skill: Perceived lack of skill can result in a discount to NAV if shareholders believe that poor management is eroding fund NAV.
• Liquidity Transformation: Concentrated institutional ownership in CEFs can reduce theliquidity of floating shares, making them less liquid compared to the fund’s underlying assets.
• Distribution Policies: Policies affecting payouts can influence discounts or premiums.
• Discount-aggravation Strategies: opportunistic investment strategies aiming at worsening the discount (e.g., by reducing liquidity transformation) to profit from (eventual) fund liquidation following management/board replacement.
• Asset Allocation and Risk Misalignment: Managers might take on too much or too little risk compared to what shareholders desire, therefore leading to greater discounts.
• Management Fees: High management fees can be a deterrent, leading to a discount.
• Domestic Bias and Lack of International Exposure: Closed-end funds investing primarily in their home exchange suffer from larger discounts due to lack of retail investors’ benefits from exposure to international assets.
• Tax Liabilities: Potential tax burdens from unrealized capital gains—This does not apply to Malaysian CEFs.
• Sentiment and Noise Traders: Irrational trading can drive prices away from NAV.

ICAP’s Risk-adjusted Performance vs. KLCI Index

• The cumulative Information Ratio (IR) suggests that ICAP has been successful in generating excess returns relative to the benchmark (KLCI) for each unit of active risk taken.
• Additionally, the cumulative Sortino ratio (SR) indicates that the fund has effectively managed downside risk, achieving superior returns relative to the negative volatility. In economic terms, this suggests skilled management and a successful strategy in capitalizing on market opportunities while effectively managing risks.

ICAP’s Alpha (α) vs. KLCI

• The fund’s position above the SML indicates outperformance relative to the expected return for its level of risk (ERP: 5.7%).
• The estimated annual alpha for the ICAP fund is 1.8% after fees – a significant performance, particularly when compared to that of international peer funds.
• Overall, the fund has generated an annualized risk-adjusted return that exceeds what would be expected given its systematic risk-taking and prevailing market conditions.

Could ICAP’s performance Explain the Discount?

• Information Ratio (IR): For every unit increase in the IR (blue line), the premium is expected to increase by only 0.3672 units, all else equal. The p-value of 0.077 suggests that this relationship is insignificant.
• Sortino Ratio (SR): For every unit increase in the SR (green line), the premium is expected to increase by only 0.5042 units, holding all else constant.
• Implication: Boosts in fund performance do not seem to drive the discount of the fund⇒ Other factors are therefore likely to drive ICAP’s discount.

ICAP Discount — A ”Horse Race” of Factors - And the Winner is...

• Neither ICAP’s asset allocation nor its returns in excess of the KLCI are a significant determinant of the discount—after controlling for institutional holdings.
• For every percentage point increase in % of Instn Holdings, the monthly ICAP discount increases by about 1.62%, holding other factors constant.
• At the 1% level, only the percentage of institutional holdings remains a significant determinant of ICAP’s monthly premium/discount.

Institutional Trading, Adverse Selection and Secondary Market (Il-)liquidity

Interpretation:

• An increase in buy-side institutional trading leads to a decrease in abnormal retail trading volume in the next 1-10 days—i.e., lower market liquidity.
• By contrast, an increase in sell-side institutional trading leads to an increase in abnormal retail trading volume in the next 1-10 days—i.e., greater market liquidity.

Granger Causality test — Discount vs. Instn ownership

• At lag 0 (the time of the shock), the response is zero, as expected.
• At lag 1 (1 week after the shock), there is a noticeable response of the ”Weekly Premium/Discount” to the shock in “% of Inst. Shh”. From lag 2 onward, the response remains relatively stable and within the confidence interval.
• Unreported result: A shock in the ”Weekly Premium/Discount” does not Granger-cause the “% of Inst. Shh” over the time period.

Interpretation: The 1-week response (lag 1) of the ”Weekly Premium/Discount” to a shock in “% of Inst. Shh” is approximately 4.11— a one-percentage shock (increase) in the “% of Inst. Shh” leads to a 4.11% increase in fund’s discount during the following week.

Forecast Error Variance Decomposition (FEVD) of ICAP’s Discount

• Immediate Effect (Week 1): At the very beginning, shocks in “% of Inst. Shh” account for a relatively small fraction of the variance in ”Weekly Premium/Discount”.
• Increasing Influence Over Time: The influence of shocks in “% of Inst. Shh” on the volatility of the weekly discount rises gradually over the weeks. This trend suggests a growing impact of changes in institutional ownership on the volatility of the discount/premium over the medium to longer term.
• Stabilizing Effect: After an initial increase, the proportion of variance attributed to “% of Inst. Shh” seems to stabilize, indicating a consistent influence of institutional ownership on the volatility of the discount/premium in the longer term..

Concluding Remarks

• Performance Metrics: ICAP has consistently demonstrated a superior risk-adjusted performance vs. KLCI.
  • Annual Sharpe ratio:0.38
  • Jensen’s alpha: 1.8%
  • Annual IR: 0.48
• Discount Dynamics: ICAP’s persistent discount to NAV suggests the influence of factors beyond mere fund performance or asset allocation.
• Institutional ownership: The empirical findings seem to suggest that as institutional ownership increases, the premium tends to decrease or the discount tends to increase.
• Possible explanation:
  • Institutional investors frequently hold substantial holdings in closed-end funds. This concentrated ownership can occasionally constrain the daily availability of shares for trading in the open market, commonly referred to as the ”float”.
  • A smaller float can lead to lower market liquidity if fewer shares are available for daily trade.
  • Lower liquidity can result in larger bid-ask spreads, potentially contributing to the discount experienced by closed-end funds.
  • When individual investors perceive difficulties in trading funds’ shares or face adverse selection costs, they might require rationally larger discounts to NAV.