A couple years ago, the infamous Flash Crash sent stocks tumbling, with the Dow Jones Industrials (INDEX: ^DJI) falling a thousand points in a matter of minutes before rebounding to earn back most of those losses. The incident shook investor confidence for months and raised questions about whether computer programs that have dominated trading for years could be trusted to avoid such episodes in the future.

Last week, another Flash Crash happened. It didn't hit the Dow or any other well-known stocks, but it nevertheless wrought havoc in a highly specialized part of the market. For closed-end funds that focus on income-producing securities, last week was yet another example of how market volatility can have a huge impact on illiquid markets.

What happened?
Leveraged closed-end funds that pay high dividends have been extremely popular lately. For instance, with a distribution yield of 13%, the Pimco High Income Fund (NYS: PHK) entered last week carrying a 42% premium to its net asset value, meaning that investors were willing to pay $1.42 for every $1 of assets on the fund's books. Similarly, the Aberdeen Asia-Pacific Income Fund (ASE: FAX) , which focuses on bonds from Australia and other Pacific Rim countries, traded at a much more modest premium of 2%.


But last Wednesday and Thursday, all that changed. Both closed-ends, along with a host of others, saw big share price drops, with the Pimco fund losing more than 10% and the Aberdeen fund down almost 8%. As a result, the Aberdeen fund traded at nearly a 6% discount to its net asset value, while the Pimco fund's premium shrank by nearly half to 22%.

On Friday, though, the funds both regained much of their lost ground. A better than 10% gain for the Pimco fund pushed its premium back up to 35%, while the Aberdeen fund picked up more than 4% to trade at a smaller discount of just 1.5%.

A slow flash
At first glance, this may not seem anything like the Flash Crash. After all, this event took days to play itself out.

But to understand why the episodes are similar, you need to understand the ins and outs of the closed-end-fund market. As the precursors to exchange-traded funds, closed-ends are mutual funds that trade on a public exchange. But unlike ETFs, the companies that manage closed-end funds don't constantly stand ready to issue new fund shares or redeem existing ones, even for institutional investors. As a result, closed-end shares can trade at huge premiums or discounts for extended periods of time, because there's no mechanism to allow investors to use arbitrage to eliminate market inefficiencies directly. For instance, the gold and silver bullion closed-end Central Fund of Canada (ASE: CEF) has traded at an average premium of about 7% over the past five years, in part because of its tax advantages over holding bullion directly but also because of its convenience and bullion backing. Adams Express (NYS: ADX) , on the other hand, has traded near its current discount of around 15% pretty steadily for years, despite its owning the same blue-chip stocks that many traditional mutual funds and ETFs own.

Moreover, closed-end funds don't have anything close to the trading volumes that stocks in the Dow have. Even the Pimco fund, which has gained notoriety due to the outspoken advocacy of manager Bill Gross, only trades around $12 million in shares on a typical day. The Aberdeen fund has even less volume, with roughly $5 million in daily trading on average. When investors decide they want to buy or sell closed-end fund shares in mass, even small amounts of pressure can move the market wildly -- and in a serious move, liquidity dries up very quickly, leading to small Flash-Crash-type events.

Guard yourself
Because of the unpredictability of the markets, it's especially smart when you're buying or selling shares of stocks or funds that don't have much trading volume to use limit orders. You run the risk of not having your order executed, but in a big downdraft that often turns out to be temporary, that risk is worth it in order to protect yourself against potentially having a market order execute at a price far different from what you expected.

However, don't let the higher volatility of thinly traded investments scare you out of using them entirely. If you're smart about taking advantage of the opportunities that less experienced investors give you when they fall into traps, closed-end funds and other illiquid investments can be very profitable.

Flash crashes give you smart opportunities to take advantage of, but overall, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

The article The Flash Crash You Missed Last Week originally appeared on Fool.com.

Fool contributor Dan Caplinger owns shares of Central Fund of Canada. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Bonds for Beginners

Learn about fixed income investments.

View Course »

Income Investing

Grow your nest-egg.

View Course »

Add a Comment

*0 / 3000 Character Maximum