If arbitrage is costly and noise traders are active, asset prices may deviate from fundamental values for long periods of time. We use a sample of 158 closed-end funds to show that noise-trader sentiment, as proxied by retail-investor flows, leads to fluctuations in the discount. Nevertheless, we reject the hypothesis that noise-trader risk is the cause of the long-run discount. Instead we find that funds which are more difficult to arbitrage have larger discounts, due to: (i) the censoring of the discount by the arbitrage bounds, and (ii) the freedom of managers to increase charges when arbitrage is costly. * Faculty of Finance, City University Business School, London. We would like to thank the editor, Richard Green, and especially the anonymous referee for constructive suggestions in improving the paper. Other helpful comments were made by Meziane Lasfer, Mark Salmon and seminar participants at City University, Maastricht University and the European Financial Management Association (June 2000).
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