How a Closed-End Fund Can Outperform Its Own Stock Portfolio

Using a corporate valuation model with personal taxation, this study explores an arbitrage opportunity allowing any public corporation classified under the U.S. law as closed-end investment company to systematically earn an abnormal return by giving up the privilege of pass-through income taxation in favor of regular corporate taxation and reinvesting a high enough ratio of its earnings in the stocks of other U.S. corporations. For the sake of illustration, the market value of an all-equity investment company fully invested in stock may systematically exceed the value of the company's own portfolio even if only 1/3 of the company's earnings are regularly retained. Theoretically, as the reinvestment ratio approaches unity, the market value of the company will diverge! The cause for the price premium attainable in this fashion is the opportunity to reinvest earnings at a rate of return that exceeds the opportunity cost of retained earnings. Since market-priced stock investments are in unlimited supply, the scope of abnormally profitable investments is constrained only by the investment company's growing flow of earnings. The analysis presented raises a larger issue about similar opportunities available to all corporations. Contrary to general perception and the intent of the law, the partial taxation of income earned by any corporation from inter-corporate stockholding does not to prevent systematic abnormal return (and the incentive to agglomerate), while formal restrictions on excessive retention of earnings by Sections 531-533 of the Internal Revenue Code remain unenforceable