Description

This idea exploits a rare gift from the “Wall Street tooth fairy” offering investors the opportunity to buy a basket of commodities for $700k and immediately sell these commodities for $1mil. Because this discount can be geared an investor has the opportunity to swap $1.0mil for $3.3mil over 38months. (Hopefully less)

 DESCRIPTION

The Close Enhanced Commodities Fund (CED.LN) is a closed-end fund listed in London. The fund was launched in February 2005 issuing 35.3million shares at GBP1.00. The IPO raised GBP 35mil of which GBP 33mil was used to buy debt securities that were designed to meet the following investment objectives.

-          To mirror the performance of a geared (2 times at inception***) commodity portfolio consisting of 1/3 oil, 1/3 gold, 1/9 copper, 1/9 aluminium and 1/9 zinc.

-          To guarantee a minimum price of GBP1.00 on the redemption date in February 2010.

These objectives are expressed by the following pricing formula

Price = GBP1.00 + maximum (  0 ,  2 * Growth of Commodities Portfolio since inception)

As you will see in the calculation below the commodities portfolio is up 66% since inception. This implies a theoretical price for the fund of GBP2.31 (1.00 + 2*66%).  For some strange reason the fund is currently trading at GBP1.57 which implies a 32% discount to the theoretical price. This discount offers very attractive arbitrage and gearing opportunities with large returns on invested capital.

GROWTH IN PORTFOLIO

The commodity portfolio has grown by 66% as illustrated in the table below.

As we saw above the 66% growth implies a theoretical price of GBP2.22 and a theoretical market cap of GBP81.6 million. (Current price = GBP1.57, Current MCap = GBP55.4 mil)                                                                               

*Note *****************************

The prices used by CED to value the portfolio are:

Oil = Closing price of NYMEX Exchange near crude oil future

Gold = London afternoon fixing price

Aluminium, Copper, Zinc = London Metals Exchange (LME) Cash Price in US Dollars per metric tonne.

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AMOUNTS TO BE HEDGED

On the launch of the fund GBP33.1mil of the IPO proceeds were invested in debt securities leaving GBP1mil cash on the balance sheet after listing expenses.

In order to lock in the discount investors need to know how much of each commodity to hedge out. To do this one needs to determine the current weighting for each commodity in the portfolio. This is done by growing the initial positions by the appreciation in each price since inception. (See the above table for growth rates.)

Given the change in price since inception  the current weighting of the portfolios are Oil (25%), Gold (30%), Aluminium (9%), Copper (14%) and Zinc (22%).

To determine the amount of each commodity to be hedged in GBP these weighting are multiplied by the theoretical market cap of the fund less the GBP1mil in cash. (81.6– 1.0 = 80.6).

The amounts to be hedged are as follows: Oil (GBP 20.2mil), Gold (GBP 24.2mil), Aluminium (GBP 7.5mil), Copper (GBP11.3mil) and Zinc (GBP 17.4mil).

GEARING THE RETURN

The existence of an oil ETF (USO) and a gold ETF (GLD) provide the ability to gear the return on invested capital as described below.

Assuming

• the whole fund is bought for GBP55.4 million (the actual market cap)
• the Aluminium, Copper and Zinc positions are hedged out in the US or London futures markets.
• ETF’s are used to hedge out the oil and gold positions

Shorting the ETF’s implies that an investor will receive GBP44.4mil in his account. This means that he only requires GBP11.0mil of his own capital for the investment. This ability to gear provides enormous leverage as a 10% narrowing of the discounts generates a 74% return on capital. Obviously, the leverage is unfavourable if the discount widens but this is not a permanent loss. Assuming the discount narrows to zero by maturity (Feb 2010) implies that the GBP11.0mil grows to GBP37.2mil over the 38months.

Investors who find it difficult to hedge in the futures market can limit their short positions to the gold and oil ETF's. In this case investors end up paying GBP 11.0mil for a GBP 36.1mil portfolio of Aluminium, Copper and Zinc plus GBP 1mil in cash. Deals like this should impress the neighbors. 

HISTORICAL DISCOUNT

A history of the discount/premium of actual prices vs theoretical prices since the fund was launched is shown below.

A general observation is that the discount appears to widen as commodities rise and narrow as the basket of commodities falls.

If this relationship persists then the recommended “trade” makes money when commodities fall in price and can therefore be used to hedge other positions which are long these commodities. To me this is an extremely efficient short against other commodities because the 30%discount ultimately implies a positive carry on the hedge.

RISKS

Remember that the fund invested the proceeds of the IPO in debt securities which are designed to mirror the investment objectives described above. While the prospectus warns that the expected returns will not be achieved if these securities default it also points out that all these securities have an investment grade rating.

A factor to consider when determining the likelihood of default is that the Fund is managed by Close Fund Management, a subsidiary of the Close Brother Group, a listed and reputable UK merchant bank. Good reputations are at stake and I think it is unlikely that the fund would have been launched unless the threat of default was remote. If more assurance is required, the fund managers did take my calls and were very helpful.

CONCLUSION

This trade offers 3 alternatives to take advantage of the 32% discount of CED.LN to its theoretical price.

1. Arbitrage, buy GBP81.6mil of commodities for GBP55.4mil. Lock in this return using futures and ETF’s. Because ETF’s can be used an investor effectively swaps $11mil for $36mil over 38 months.
2. Using only the ETF’s as a hedge implies that an investor is able to purchase $37mil of Copper, Zinc and Aluminium for $11mil.
3. In the short term the discount appears to narrow when commodities fall and vice versa making it an ideal hedge against other long commodity positions. In the long term, this is the ultimate hedge against other commodity longs as the discount effectively means that investors are paid to hedge.

 (***Please note, that the pricing formula implies a gearing of 2 on inception. Now that the portfolio has run 66% the gearing has fallen to 1.5. For more information on the fund use this link www.closefm.com )

Catalyst