Manage Money and Income Sucessfully

For discouraged investors, other products are available. Closed-end funds (CEFs) are mutual funds that are sold on the exchanges like stocks. Openend mutual funds are sold directly to investors; every dollar invested adds to the assets under management and management fees. After an initial public offering to raise capital, CEFs are bought and sold between investors at whatever price investors are willing to pay. The price of a CEF can be higher or lower than the value of the stock held by the fund. CEF managers are only able to offer new shares if returns have been good and the fund becomes popular. However, the prices of CEFs are volatile.

Closed-end funds are subject to mass psychosis. When certain stocks are hot, CEFs owning those stocks can sell for several times net asset value (NAV). Investors often experience overconfidence and grandiosity. When these stocks are unpopular, CEFs plunge to a fraction of NAV. When CEFs linger below NAV for long periods of time, frustration sets
in. Often shareholder suits are filed to open up the fund and distribute assets at NAV. CEFs are also subject to management changes and style changes. In addition, CEFs are often taken over by outside management companies and converted into larger funds. Spreads and commissions on CEFs are often painful. Closed-end funds are outside the comfort zone of most mutual fund investors.

CDOs gained a bad reputation of being extremely illiquid when the product was first introduced. Therefore, it should come as no surprise that new investors question the depth of the secondary markets. When the credit markets hit bottom in 2002, secondary trading in CDOs began to proliferate.

Most dealers now have secondary trading desks and make markets in each others’ transactions. As a result, bid-ask spreads have narrowed substantially since early 2000.

Clearly, the narrowest bid-ask spreads are found at the top of the capital structure. In 2006, however, even equity bid-ask spreads (particularly for CLO equity) narrowed. As with all financial products, liquidity evaporates during periods of high volatility.

We believe equity investors should assume they are buying to hold, and any liquidity they receive should be viewed as a bonus. As for note investors, the key to avoiding a liquidity crunch is to stick to straightforward, easyto-model CDOs. Third-party software has been instrumental in helping secondary trading desks make a market in each others’ deals. If the structure is too esoteric, however, it may not make it into the vender’s database. In that case, an investor would most likely only have the underwriter to turn to when it comes time to sell.

The growth of the credit default CDO (CDCDO) market should, in the long run, continue the trend toward a more liquid secondary market. It could also lead to a few traffic bumps in the short term. A CDS contract requires one party to go long the risk, while another is effectively short. This fact alone opens the door to speculators who help provide liquidity, but who also increase market volatility. Higher market volatility leads to wider bid-ask spreads.