Closed end fund (CEF) arbitrage and premium/discount theory

I found this excellent paper through the Simoleon Sense blog, which I think very highly of and read attentively. Their post: http://www.simoleonsense.com/attention-graham-dodders-new-paper-closed-end-funds-activist-investors-whats-the-attraction/

The link to the paper they discuss: http://yesandnotyes.com/blog/wp-content/uploads/2009/12/deo-Closed-End-Funds-and-Activist-Investors.pdf

The Simoleon Sense post:

Attention Graham & Dodders: New Paper Closed End Funds & Activist Investors: Whats The Attraction?

January 2, 2010

One of my very good friends Doug has put together a  paper on activist investing and closed end funds. Doug is the mastermind behind the yes & not yes blog.

Click Here To Read: Closed End Funds & Activist Investors: Whats The Attraction?

Abstract (Via Douglas E. Ott, II @ Yes & Not Yes)

This paper offers a basic description of why activist investors are attracted to closed-end funds and how this affects the rights of the closed-end fund shareholders. Part II provides a general description of the closed-end fund structure and a review of the research that attempts to answer why most closed-end funds trade at discounts to their net asset value (NAV). Part III outlines the reasons closed-end funds are attractive opportunities for activist investors. Part III also provides a detailed account of three proxy contests that occurred between activist investors and incumbent directors of closed-end funds: (1) the activists failed in their contest and there were no positive effects for shareholders as a result of their efforts; (2) the activists failed in their contest and there were positive effects for shareholders as a result of their efforts; and (3) the activists were successful in their contest and were able to enact measures that benefited shareholders. These real-life examples illustrate the motivations of the activists (e.g., return on and of their investments, concern for shareholders’ rights) and also the problems that seem inimical to closed-end funds (e.g., unitary boards, conflicts of interest, fund shares that trade at large discounts to NAV). Part IV argues that, contrary to the feelings of the managers and directors of closed end funds, activist investors can be a desirable element for all investors in the targeted closed-end funds as they may be able elect directors that are more independent and are often able to decrease the discount to NAV just with an announcement of a proxy contest.

Merger arbitrage strategy update

The Reformed Broker cites a very interesting study put out by The Boston Consulting Group (BCG) that suggests that M&A activity is expected to materially increase (they’re looking at European companies, but there are few reasons why the US won’t behave similarly, like FX rates). Bottom line: merger arb strategies need deals to invest in, and more deals means more potential investment opportunities in the merger arb space. The more opportunities, the better the prospects for solid returns, as a low-deal environment forces more crowded trades in the merger arb space which historically is negatively correlated with spreads/discounts to takeover prices. More activity is good for the merger arb funds. There are a number that I’ve discussed previously, including ARBFX, MERFX, GABCX, and GDL.

Their post: http://thereformedbroker.com/2009/12/23/a-european-buyout-frenzy/

They state: “It was only a matter of time.

The recent rally notwithstanding, corporations and their assets denominated in US dollars are lookin’ like lunch meat to the European business world and according to a recent study, a wave of mega-mergers is on the way.

The Boston Consultant Group is out with a survey that indicates 1 in 5 European companies is planning to do a deal in 2010, and that percentage jumps to 1 in 2 companies with market caps in excess of €20 billion.

68% of the companies surveyed were pondering “horizontal” deals, meaning mergers within their own industry segment for the purpose of scale and the easing of competition.

BCG broke the results down by industry group (see chart below):

While to be sure, a great many of these deals will take place on the European continent, something tells me that the Kraft/Cadbury game of footsie we’re witnessing is only the canary in the coalmine in terms of Transatlantic mergers (although in this case, it’s an American company bidding for Euro assets vs Nestle, another European company).

One bright spot for the global economy is the fact that 44% of chemical companies have the urge to merge, as the chemical industry is often seen as a harbinger of economic activity.

Research Recap has the rest of the stats as well as a link to the full report.

Sources:

1 in 5 European Companies Planning M&A Deal in 2010  (Research Recap)“

Taxable vs. tax-free accounts: where do you hold your investments?

First, let’s just assume that you have two investment accounts: a personal investment account and a tax-advantaged (tax free) IRA

Hold in a taxable account:

Commodity funds: If they invest in the actual commodities they won’t pay significant distributions/dividends like natural resource / commodity funds that buy equities of companies whose operations are based on the actual commodities. Since there are low distributions, and presumably you’re holding commodities as a core investment holding for asset allocation purposes and as a hedge against inflation, you probably plan on keeping your commodity holdings for longer than one year. If so, that means your sales will be classified as long-term capital gains, so the tax hit is only about 15%

Biotechnology funds: Biotech companies have little or no dividends, in general, so there’s little to no current income. Assuming again that this is a long-term holding, you probably hold it for over a year, which again means the long-term capital gains tax hit is only about 15%.

Covered call funds: Since covered call funds have long-equity exposure, I prefer to hold them in my taxable account because, should they decline, I can take tax losses against other long-equity positions b/c that’s where I hold single stock and other equity positions (like emerging market equity ETFs). I try to hold all my long-equity positions over one year to get long-term capital gains tax treatment, but if you’re a short-term trader then you should probably do so in your tax-free account to avoid the higher short-term tax impact. Keep in mind that you can’t take tax losses on your investments in a tax free account, so if you do lose money you can’t sell your losers to offset taxes on your winners.

Long/short equity funds: I hold them in either my taxable or tax free accounts, but at the moment I prefer to hold them in my taxable account because they don’t really distribute investment gains or dividends with frequency or meaningful size. If you have a long/short equity fund in your tax free account, and the tax free account allows you to sell after time without realizing any capital gains taxes at all, then it makes sense to keep it there if you’re willing to hold on for a long time horizon.

Private equity ETFs: They distribute some dividends, depending on the holdings of the ETF (some PE firms that are listed pay dividends and some don’t). I personally look at the PE sector as a unique investment at the moment because of their unusual volatility over the last two years or so, so I don’t think I’ll sit on my private equity ETF holdings indefinitely, so I keep it in my taxable account.

Buyback / repurchase ETFs: Companies that have large repurchases have opted to allocate their capital towards returning it to investors and doing so via buyback and not dividend, hence the dividend income is pretty small. As a result, it’s basically a capital appreciation investment, and since I hold that type of investment longer than a year to qualify for long-term capital gains tax rates, I keep it in my taxable account.

MUNICIPAL BONDS / MUNI BOND FUNDS: THESE SHOULD ALWAYS BE HELD IN YOUR TAXABLE ACCOUNT BECAUSE YOU DON’T PAY TAXES ON THEM ALREADY. That’s the point of holding munis, so there’s little logic in holding a tax free investment in a tax free account, because it’s redundant.

Hold in a tax-free account:

Real estate funds: Most real estate funds generate significant current income via dividends, and REIT dividends actually do NOT qualify for the lower qualified dividend tax rate. Additionally, most real estate funds have high turnover (though not all do) so you avoid their short-term capital gains exposure by holding it in a tax-free account.

Emerging market debt: They pay out non-qualified interest income frequently and a good portion of their capital gains tend to be short-term, so I hold them in my tax free account.

Merger arbitrage funds: They have VERY high turnover because most deals get closed in less than a year, so they have significant short term capital gains issues, hence I hold it in a tax free account.

Closed end fund (CEF) fund of funds (FoF) CEF FoF: They pay out a ton of distributions that usually do not qualify for lower dividend tax rates.

Currency funds: Their distributions need to be shielded from taxes, but not all pay significant or frequent distributions, so you need to look at the history of the actual funds themselves before you decide.

Floating-rate /variable rate debt funds: The vast majority of them invest in senior bank loans that are not tax exempt, so you try to shield the taxable income by keeping them in a tax free account.

Strategies For Uncertain Times: Closed-End Fund Fund-of-Funds (CEF FoF) and CEF arbitrage

Overview: When it comes to closed end fund (CEFs) arbitrage, I focus on buying CEFs trading at unusually large discounts to NAV in either sectors or asset classes in which I want long-exposure, or trying to arbitrage the discount itself. I incorporate analysis of which funds are most-likely to mean-revert to their historical discount to NAV, which generates price appreciation, and makes the “CEFs at a discount” a strategy on its own. Additionally, I hedge certain CEF positions with offsetting short positions against the underlying assets of the CEF and hope for mean reversion of the discount, which is commonly called closed end fund arbitrage. CEFs are complex and unloved, which means doing your own homework is required, particularly as it relates to holdings, distributions, tax considerations, and discount/premium changes.

Closed end fund Fund-of-Funds (CEF FoF) seek to generate current income and capital appreciation from the CEFs that they hold, and can be hedged or arbitraged in many cases by shorting against the CEF FoF to try an exploit the inherent double discount of a CEF which trades at a discount that hold other CEFs that are also trading at discounts.

Closed-End Fund Fund-of-Funds (CEF FoF)

Overview: Captures widening CEF discounts and generates consistently high current income. CEF distributions are fully-taxable as ordinary income so only hold them in a tax advantage account.

• CEFs:
  • FOF: Cohen & Steers Closed-End Opportunity Fund
    • It’s a fund of funds for CEFs that are equity & income oriented
    • Very diversified, CEF expert picks the investments
    • It’s a play on CEF discounts in general, just buy FOF for the yield
    • 0.95% annual fee
    • EFFECTIVE discount is almost double b/c the CEFs that FOF buys are already at a discount
• ETFs:
  • GCE: Goldman CEF FoF ETN
    • Buy CEFs at a discount
    • 1.0% annual fee

Other Notes:

• Good arb is to be long FOF at a discount and short GCE (which is at par) against it

Strategies For Uncertain Times: Short / Bear Funds

Short/Bear funds

Overview: Provides upside should equities decline, however, will be a drag on returns over long-term b/c long-term trend for equities is consistently positive. Only makes sense if you have large long-equity holdings and you want to reduce your overall portfolio volatility or are very cautious about equities in general. There are a TON of ETFs that are “short” various indexes with leverage, and try to generate 2x or 3x the decline in their underlying securities. However, for several reasons that are probably a bit too complex for the vast majority of investors, these ETFs do not accurately reflect changes in the underlying securities the way that they are assumed to on a short-to-medium term basis. Hold in a taxable account so that if the market declines your short/bear position gains will be covered by bigger losses in long-equities positions.

• Open-end mutual funds:
  • BEARX: Federated Prudent Bear
    • Not always net short
    • Underperf GRZZX in 2008, better performance all other years, even up mkts
    • 5% load, 1.8% annual fee
  • GRZZX: Grizzly Short Fund
    • Quant based
    • US only
    • Better 2008 than BEARX, much more volatile LT returns
    • No load but 3% annual fee
• ETFs: (you can clearly short the index ETFs as opposed to being long these inverse-index ETFs)
  • SH: S&P short
  • PSQ: Nasdaq short
  • RWM: Russell 2000 short
  • SBB: S&P Small-Cap 600 Short
  • EUM: Emerging market equities (MSCI) short
  • EFZ: Emerging market equities (MSCI) short

Strategies For Uncertain Times: Merger Arbitrage (and Special Situations)

Overview: Merger arbitrage involves long/short equity positions in an attempt to exploit M&A takeover mispricings. In some ways the merger arbitrate strategy can’t be divorced from general “special situations” strategies like spin-offs and corporate reorganizations.

Merger Arbitrage/Special Situations

Overview: Low correlation with S&P. Current historically high levels of corporate balance sheet cash balances combined with unfreezing of credit markets should lead to more M&A activity and benefit merger arb strategies. Merger arb strategies throw off lots of cap gains b/c of high turnover on deals so it’s best to hold it in a tax advantaged account.

• Open-end mutual funds:
  • ARBFX: Arbitrage Fund
    • ¼ the size of MERFX, might mean they can get out of blown deals easier
    • Mgmt focuses on strategic deals, not LBOs, and is focused on vol-adjusted returns
    • 1.9% annual expense
    • 5.28% std dev on 3 year basis, has roughly 0.40 beta w/ S&P
    • 5 year annualized return of 4.7%
    • 65 positions with high turnover
    • Down 1% in 2008
  • MERFX: The Merger Fund
    • 1.5% annual expense
    • 4.96% std dev on 3 year basis
    • 5 year annualized return of 4.4%
    • 42 positions with high turnover
    • Down 2% in 2008
  • GABCX: Gabelli ABC Fund
    • 0.64% annual fee, no load
    • 4.6% std dev on 3 year basis, beta of 0.20 vs. S&P
    • 5 year annualized return of 5.3%
    • 140 positions with high turnover, very diversified, currently 100% long
    • Merger arb, special sits, value oriented common stocks, convertible bonds
    • Down 2.6% in 2008
    • Morningstar 5 star fund
    • Almost entirely US although is global in focus
• CEFs:
  • GDL: Gabelli Global Deal Fund    
    • VERY diversified
    • All special situations: merger arbitrage, spins, reorgs
    • Global, but almost all US at the moment
    • Existing holders are buying at the moment
    • 90 positions with high turnover
    • Low annual fees of only 0.66%
    • Only 3 year history, but has a 0.65 beta w/ S&P
    • Down 8% in 2008
• ETFs:
  • MNA: IQ ARB Merger Arbitrage ETF
    • Does NOT actually short shares of the acquirer, only indexes, so it’s not real arbitrage
    • Just started
    • 0.75% annual fee

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.