CEF Long-Short Pair Trade: Premiums vs. Discounts

Includes: CRF, CUBA, EQS
by: Asif Suria

Instead of featuring two individual stocks in my monthly newsletter, I figured I would do something different in this time and discuss an interesting strategy related to closed-end funds [CEF] in detail.

What are closed-end funds?

Closed-end funds are investment companies like mutual funds with a few key differences. Just like mutual funds, closed-end funds charge management fees and consist of a basket of stocks, bonds and other assets. However unlike mutual funds, closed-end funds trade on a public stock exchange and can be purchased or sold just like you would buy or sell a stock. In this way, they are more like Exchange Traded Funds and this might explain why the website ETFConnect.com refers to them as "closed-end ETFs." To learn more about closed-end funds check out this description on the SEC website or this page on ETFConnect.com.

Premiums and Discounts

Once formed, closed-end funds do not issue any more shares and investors who want to buy into the fund must do so by purchasing it on a public stock exchange. Hence the price of these funds depends more on supply and demand instead of the value of underlying assets. This creates situations where some closed-end funds sell at a discount to its underlying basket of stocks (or other assets), while others sell at a premium to its net asset value [NAV].

A good example of funds selling at a premium are the closed-end funds India Fund (NYSE:IFN) and India Investment Fund (NYSE:IIF), which were the only options for investors who wanted to invest in India but did not want to purchase individual ADRs like Wipro (NYSE:WIT) and Tata Motors (NYSE:TTM). Over the last two years both IFN and IIF have traded at a premium to their underlying assets with the premium ballooning to more than 30% for the India Fund in the second quarter of 2006. After the May 2006 crash in emerging markets that probably reduced investor's appetite for India and a rights offering (pdf file) that increased the number of shares, the premium of the India Fund has shrunk to its current level of just 2.16%.

Similarly some closed-end funds that are not in as much demand as the India fund often trade at a discount to their underlying assets or NAV. While uncommon, there have been instances where certain closed-end funds have traded at premiums of as much as 100%. For such a fund, you would be paying $2 per dollar of underlying assets held by the fund. On the flip side, if a fund traded at a discount of 50%, you would be paying 50 cents per dollar of assets held by the fund.

How Do I Figure Out These Premiums and Discounts?

The website ETFConnect.com has made it extremely easy to figure out not only the premium and discounts of individual closed-end funds, but it also has a very handy tool to display the funds that are selling at the largest discounts and premiums. For example if you want to see the premium or discount of the India Fund, you can go to ETFConnect.com and enter the symbol IFN in its search box. To figure out the funds selling at the largest premiums or discounts, you can use their Fund Sorter tool.

So I understand what closed-end funds are and how to look up their premiums or discounts. Now what do I do with this information?

Applying this information to the principle of "reversion to the mean" or in other words "what goes up must come down", could create some interesting opportunities for investors. Funds that trade at a large discount to NAV are likely to narrow that discount at some point, leading to an increase in price of that fund assuming the price of the underlying assets remains unchanged. Similarly funds that trade at a large premium are likely to narrow that premium at some point, leading to a drop in the price of that fund assuming the price of the underlying assets remains unchanged. In the case of the India Fund, while the Indian stock market and individual ADRs like Wipro and Tata Motors appreciated a lot over the last seven months, the India Fund lost money because the premium narrowed from 28% to 2% as you can see from this chart.

Investors could use this information in combination with a various long/short strategies to create some very interesting hedged (low risk) or profit maximization opportunities. Long/Short strategies are discussed below.

Long/Short Strategy

Long/short strategies involve going long (purchasing) a stock or financial instrument (options, ETFs, etc... ) while simultaneously going short another stock or financial instrument to create a paired trade. This is sometimes done to reduce risk and in some instances to increase profit. For example, if you believe that Intel (NASDAQ:INTC) is likely to do well in 2007 with its new line of processors and take away market share from AMD (NYSE:AMD), in a regular scenario you would buy Intel stock but not AMD. Now if you are convinced that Intel will do well and AMD will do very badly in 2007, you can try to increase your profit potential by buying Intel and simultaneously shorting AMD so that you benefit from the price of Intel increasing and the price of AMD falling. Unfortunately you have also increased your risk with this "directional bet."

Long/short strategies can also be used to reduce risk as illustrated in the following example. Let us still assume that you like the prospects of Intel in 2007. However you realize that a dropping tide brings down all boats and that the price of Intel is highly correlated to that of the semiconductor index [SOXX]. So even if Intel is likely to do well in the long-term, there is a risk the stock might go down if the semiconductor index is dragged down by its other components like AMD. To hedge against this risk, you could go long Intel while simultaneously going short the semiconductor ETF (NYSEARCA:XSD). This way even if the semiconductor index were to fall and drag down Intel with it, your losses in Intel would be offset by your short position in XSD.

The Trade

We can use long/short strategies with closed-end funds to maximize profits or to create an arbitrage opportunity. Using the Fund Sorter tool on ETFConnect, we can see that the two funds with the largest premiums are Herzfeld Caribbean Basin Fund (NASDAQ:CUBA) with a premium of 87.15% and the Cornerstone Total Return Fund (NYSEMKT:CRF). The premium on CUBA is probably a little lower as the data on ETFConnect is from 1/30/2007 and not from 1/31/2007 like the rest of the funds.

Similarly we can also get the two funds with the largest discounts and they are Equus Total Return (NYSE:EQS) and Canadian World Fund Limited [TSE:CWF] with discounts of 26.59% and 16.69%. A simple profit maximizing strategy would be to go long EQS and CWF while simultaneously shorting CUBA and CRF. Please note that if you short a stock or fund, you are then responsible for all dividend or distribution payments. CRF pays out monthly distributions of 17.8 cents and its annual distribution rate is 11.45%. Could this be the reason this fund is trading at such a high premium?

According to Herb Greenberg, these high distributions are a red flag. In the comments section of Herb's blog, investors also discuss how hard it has been to short either CUBA or CRF. A big institutional investor may still be able to pull off such a trade but since this trade may not be accessible to all investors, I will not add it to the SINLetter model portfolio.

One part of the arbitrage (or low risk) trade would be to short CUBA, which has gone up on speculation that with Fidel Castro out of the picture, the trade embargo on Cuba (the country) would be lifted and companies based in the Caribbean would benefit greatly. However when you look at the holdings of the CUBA fund, you will notice that nearly 60% of assets are in U.S based companies like Royal Caribbean Cruises (NYSE:RCL), Carnival Corp (NYSE:CCL) and Garmin (NASDAQ:GRMN). In fact 20% of assets are concentrated in a single railroad company called Florida East Coast Industries (FLA). So the second part of the arbitrage trade would be to go long on the top 10 holdings that constitute more than 60% of assets.

Whew! That felt more like writing a book or a lengthy article instead of an investment newsletter. It is almost 5 AM and the caffeine is beginning to wear off.