Since almost all closed-end funds tend to sell at a discount, it can appear obvious that there is no reason to purchase closed-end funds when they are selling at a premium. Sometimes a special feature, for example, a closed-end fund having a private placement in its portfolio which is about to go public as a hot issue, may justify purchase at a premium. Otherwise, it is difficult to make a case for paying a price higher than NAV.
Central to the advantages of closed-end funds is the discount; both as to dividends and as to pricing variances. Read the rest of this entry »
A primary reason for discounts is a lack of sponsorship. If a securities salesperson (dependent on commissions) has a choice of selling someone an existing closed-end fund (say at a regular stock commission of around 1 percent) or a load mutual fund with a sales charge (that can be as much as 8 percent), the incentive is to direct “investors” to the open-end fund.
The incentives associated with higher sales charges can be easily observed when new closed-end funds are issued. In new issues, compensation is by underwriting fees. A typical fee is 7 to 8 percent. If a fund was coming public at $10 per share, an 8-percent underwriting fee would be 80 cents per share. Read the rest of this entry »
In the common stock investment techniques, the most obvious hedging strategy might be to be long the stocks that are relatively discounted and sell short those that appear most overpriced. However, the process is not so simple.
Because of the composition of the Master List, the stocks as a group tend to do significantly better than the market as a whole. Consequently, although the long positions have significantly outperformed the broadly based market, the short positions, if sold, will likely provide lesser returns than the overall market.
It is because of the Master List’s positive bias that in hedging accounts Drach utilizes writing index call options as a substitute for the short side. This substitution both eliminates the effect of the Master List’s upside bias that would be experienced in attempting to short Master List stocks and provides added profitability for the short side because of premium capture. As discussed in Chap. 9, the method of going long the selected Master List issues and proportionately shorting (selling) index call options is a lethargic process, which has so far produced a constant annualized return of about 15 percent irrespective of overall market conditions. Read the rest of this entry »
A eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer (non-registered form) and is issued outside the country of the currency in which it is denominated.
Borrowers and lenders are spread around the world, while the intermediaries are spread across Europe, with the majority of business being done from London. The market was founded in the early 1960s and has provided a competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese banks, pension funds and insurance companies have become important lenders in recent years and there are still plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the world’s second largest securities market after the US bond market in terms of trading volume and the third largest after the US and Japanese bond markets in terms of debt outstanding. Read the rest of this entry »
By far, the most popular type of credit derivative is the credit default swap. It is categorized as one of two credit default products. Not only is this form of credit derivative the most commonly used stand-alone product, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations, which will be discuss later. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Because of the popularity of credit default swaps, the other type of credit default product —the credit default option—is rarely used. Hence, we will not discuss that product here.
Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In contrast, a total return swap allows an investor to increase exposure to a reference obligation. Read the rest of this entry »
An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.
The terms of an interest-rate agreement include
- The reference rate
- The strike rate that sets the ceiling or floor
- The length of the agreement
- The frequency of settlement
- The notional principal amount
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Credit default products have a payout that is contingent upon a credit event occurring. The ISDA provides definitions of what credit events are. The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions“) provides a list of eight credit events: (1) bankruptcy, (2) credit event upon merger, (3) cross acceleration, (4) cross default, (5) downgrade, (6) failure to pay, (7) repudiation/moratorium, and (8) restructuring. These eight events attempt to capture every type of situation that could cause the credit quality of the reference entity to deteriorate, or cause the value of the reference obligation to decline.
Bankruptcy is defined as a variety of acts that are associated with bankruptcy or insolvency laws. Failure to pay results when a reference entity fails to make one or more required payments when due. When a reference entity breaches a covenant, it has defaulted on its obligation. Read the rest of this entry »
The interest-rate swap was developed in late 1981. By 1987, the market had grown to more than $500 billion (in terms of notional principal amount). What is behind this rapid growth? As our asset/liability application earlier demonstrated, an interest-rate swap is a quick way for institutional investors to change the nature of assets and liabilities or to exploit any perceived capital market imperfection. The same applies to borrowers such as corporations, sovereigns, and supranationals.
In fact, the initial motivation for the interest-rate-swap market was borrower exploitation of what were perceived to be “credit arbitrage” opportunities because of differences between the quality spread between lower- and higher-rated credits in the U.S. and Eurodollar bond fixed-rate market and the same spread in these two floating- rate markets. Basically, the argument for swaps was based on a well-known economic principle of comparative advantage in international economics. Read the rest of this entry »
I am always amazed when investors fail to consider after-tax returns in assessing their performance. Perhaps this oversight is a direct result of the sin of pride—they can’t puff up their feathers and crow as loudly with an after-tax return number. Perhaps it’s a result of envy—they are driven to brag about their great results and lesser results won’t allow them to respond effectively to their feelings of envy. Perhaps it’s simply sloth— they are too lazy to think about the difference between after-tax returns and pre-tax returns or to do the math. Whatever sin causes them not to obey this commandment, they end up deluding themselves about how well their investments are doing.
Similarly, some investors sell a stock before it becomes eligible for capital gains treatment. For investors in the highest tax bracket, the difference is 15 percent instead of 35 percent if they hold the stock for a year and a day. Gluttons, of course, lack the patience to hold their stocks for that long. Angry investors, too, may be so upset that a stock has failed to meet their expectations that they may sell it because they have so much animosity toward it, heedless of the tax consequences.
If you want to adhere to this commandment, ask yourself the following questions:
- Am I using every possible dollar in tax-deferred, retirement-type vehicles, such as IRAs or 401 (k)s?
- Am I taking full advantage of 529 college savings plans?
- When thinking about fixed-income investing in a fully taxable account, am I aware of all my tax-exempt options and what the net yields are?
When your neighbor, friend, relative, or colleague makes a bundle through investing, remind yourself to manage the envy you naturally feel. If you don’t manage this envy, you’re likely to copy his strategy or type of investment. It’s possible (though unlikely) that copying it may be effective in the short-term, but it is no way to meet long-term objectives.
Viewed without any context or history, a buddy’s great investment is not always what it appears. He may have been investing in food-related companies for years without much success, but he happened to be holding one food company stock that shot skyward because of some hugely successful product introduction. You are not privy to the years of futility as he pursued this approach; all you see is that a food company investment paid off handsomely. If you try and duplicate his “strategy,” you’re doing so without seeing the whole picture. If you possessed this broader perspective, you would never attempt to use his flawed approach.
Diminish your fervor to copy other successful tactics and techniques by asking your neighbor or colleague the following questions: How long have you had this particular investment? How has it done over the last three years? Have you ever had a similarly spectacular success in the past ten years? Have you been disappointed by your investing approach over the last five years? How were you disappointed? The answers are likely to make you less covetous.
Greed is one of the most difficult sins to manage because it is always there. We invest to make money, and every promising investment raises the possibility of making a significant amount of money. We wouldn’t be human if part of us didn’t dream a bit about what might be. Good investors, though, keep that part of themselves in a controlled, isolated environment. If you are particularly vulnerable to the sin of greed, you’ll do likewise. Specifically, you’ll do some or all of the following:
- Invest slowly, knowledgably, and logically. Speed, ignorance, and reflex are the greedy investor’s enemies. Force yourself to move relatively slowly before making an investing decision, even when you’re certain that even a moment’s delay could cost you thousands. In the vast majority of cases, delaying your decision for a short period of time won’t hurt. In most instances, it helps because it gives you a bigger window of time in which you can think, reflect, learn, and talk about an investment. Greed preys on people who just react. When I say invest knowledgably, I mean do your homework. Learn about the fund’s or stock’s performance historically. Compare the fund or stock to the appropriate index or benchmark. Read as many reports as you can related to the investment. Don’t worry that your delay makes you spend an extra 50 cents a share because in the long run it won’t make a difference. Finally, logical investing means reasoning out your investment decision. When you hear a great tip or read something that makes you believe you’ve found a great fund that will make you millions, step back and write down the logical steps that have led you to this conclusion. Specifically:
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Gluttons are addicts, only instead of being hooked on food they cravethe action of trading. While people who eat a lot may grow large, people who invest a lot often see their portfolios shrink. This type of investor sells bad stocks in the hope of finding good ones and sells good performers in the hope of finding better ones. Read the rest of this entry »
Mutual funds are used by private investors and by institutions for different but overlapping reasons
Private investors use mutual funds to invest money in the hope that it will:
- grow in value, or
- provide income, or
- deliver both, i.e.. capital growth and income either to serve specific financial needs, now or in the future, or simply to enhance their prospect of wealth.
Institutions, particularly life companies and pensions funds, use mutual funds as a convenient way to organise and manage some if not all of their investment portfolios, which will have objectives similar to those of the private investors who are the ultimate beneficiaries. Read the rest of this entry »
