One of the most interesting aspects of closed-end funds that make them unique is that they typically trade at discounts to net asset value. I won't get into the academic literature devoted to explaining the magnitude and persistence of discounts or why they trade at discounts but liquidity of shares and holdings, retail investor ignorance, taxes, leverage, distribution policy, fees and performance probably all have an impact on the discount. Most literature reveals evidence of serial correlation and mean-reverting characteristics of the discount level.
As an active closed-end fund trader I typically look for funds trading at discounts to net asset value with a catalyst or event that will liquidate, open end or lead to a tender offer close to NAV. One of the best ways to find these opportunities is by following activist managers. Phillip Goldstein and Bulldog Investors is one of the major closed-end fund activist investors and I'm always following any related SEC filings.
On July 2, 2012, Thai Capital Fund (NYSEMKT:TF) announced that a proposal by the Board of Directors to liquidate the fund was not approved by shareholder vote at the annual meeting. In the 13d filing they also announced that the Board will meet to consider steps to take in the best interests of the fund and shareholders. Bulldog and affiliates believe the status quo is unacceptable and the Board should act by creating a liquidity event at or close to NAV. They also state that if the Board fails to act they may consider other options including representation on the Board.
In the August 3, 2012 13d filing Bulldog and affiliates reported purchasing additional shares and now owning 23.18% of the outstanding shares. The fund also has other 5% holders and good institutional representation that is necessary to offset retail holders that tend to vote with management.
In the most recent August 21, 21012 filing Bulldog and affiliates acquired additional shares bringing total ownership to 38.36% of the outstanding shares.
After I find a potential trade opportunity I look at the risks including the NAV accuracy, historical discount levels for my downside if no liquidity event occurs and the ability to hedge the directional risk from a long position in the fund.
How accurate is the NAV of the fund? After reviewing the most recent SEC N-Q filing it appears that all 40 million of fund assets are level I assets. So I am highly confident that the discount to NAV is real and could be realized in a liquidation.
What is the historic discount level? Using the CEF Association website I find the 10 year average discount at 7%, 5 year at 9.5% and YTD around 11%. The current discount is close to the 5 year average and it's reasonable to assume that if a liquidation attempt fails the discount would widen back to the level of the previous attempt in July. The largest discount in July was 11.36%. I figure my downside would be losing 2-3% on a discount move.
How do I hedge the directional risk? It's great to purchase a fund almost 10% below it's fair value and have it liquidated returning a nice profit the problem is the Thai market and thus the holdings and NAV will fluctuate as I wait for the anticipated liquidity event. A great way to establish a hedge is to sell short a correlated etf. The only real choice in this case is the iShares MSCI Thailand Index Fund (NYSEARCA:THD). This fund has approx 600 million in assets and borrowing shares shouldn't be a problem. My preference is usually to use an option strategy instead of shorting stock but THD has no listed options. After reviewing THD holdings listed on the iShares website I'm pretty confident in the correlation and my hedge. THD and TF both share several top ten holdings and share large sector exposures in energy and financials. The hedge should be established dollar neutral.
I have been building a long position in TF and short position in THD since Aug 6, 2012.
Disclosure: I am long TF.
Additional disclosure: Short THD