Cornerstone Total Return Fund CRF S
January 16, 2007 - 9:35am EST by
2007 2008
Price: 19.40 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 98 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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CRF is a closed end fund offering a special situation that I think is overlooked by many of the people merely short for the 90+% premium to NAV that it trades at (as an aside, I think being outright short is a very good trade, but perhaps not the optimal trade).  In fact, I think there are three more attractive structures that utilize CRF than being outright short. 


CRF’s optically high yield reflects a self-cannibalizing return of capital that, with each payment, improves the likelihood of premium collapse.  It “yields” a bit over 20% of NAV or 11% on market value.  Because of its limited size, this is an investment best situated for individuals rather than fund managers.  This write-up should also serve as a reference for those already short CRF or CLM.


Please see Pepper512’s excellent write-up from October of 2005 for additional detail.


CRF and its sister-fund, CLM, are closed end funds managed by Cornerstone Funds.  Everything said here applies to CLM as well, though it trades at a mere 50% premium (vs. CLF’s 94% premium).  Cornerstone’s Ralph Bradshaw is the primary fund manager, though one could argue he does not manage the funds so much as merely collect fees from the funds.  The funds pay 1.5% of NAV for performance that has averaged 3% below the S&P 500 since it became and all equity fund four years ago.  Not only has it trailed the S&P 500 each year for the last four years, it has trailed each quarter for the last four years.  He is kind of like Bizarre-o Bill Miller. 


CRF’s board has provided those of us that are short CRF with a gift (addressed below).  For those that do not want to risk the potential irrationality of Mr. Market and who assume that a premium that goes from 50% to 94% can go from 94% to 200%, there is a riskless arb associated with CRF that I discuss below as well. 


As a closed end fund, CRF pays a regular distribution.  Until recently, CRF followed the questionable practice of paying out a fixed amount, regardless of performance.  In November, Cornerstone announced that it is changing to a non-fixed distribution amount reset annually.  The release seemed to indicate that the distribution would be more tied to performance but simultaneous stated that for 2007, it was increasing the monthly distribution and set it at $0.178 per month or $2.14 per year or 21% of the NAV.  For all but the most legendary investors, 21% is a high hurdle.  Should performance come in below 21%, obviously CRF will have distributed capital, not income.  Given Mr. Bradshaw’s past track record, I expect a significant amount of the distribution to represent capital.  Sending back capital is an inherently unsustainable proposition and ultimately forces a cut in the dividend policy.  The worse performance is relative to 21%, the more unsustainable the distribution.


Riskless Arb:

For those that do not want to make a bet on how crazy Mr. Market can be, there is an interesting opportunity being provided by CRF’s Board.  The Board allows CRF owners to reinvest their monthly distribution proceeds into the fund at the lower of market or NAV.  In essence, this benefits investors when the fund trades at a premium to NAV.  Investors who utilize the plan can receive an instant doubling of the distribution by reinvesting at NAV and selling at market (okay, 94%, not quite a double).  This can be made riskless by going long and short identical amounts of CRF without closing out the position (i.e., boxing the position).  This will isolate the ability to take advantage of the premium at reinvestment.  Basically, with no capital at risk and no basis risk, the holder of the boxed position will receive:


Profit = Distribution * Premium


That means with today’s 11% yield, the owner of a boxed position will receive:

11% * 94% = 10.3%. 


To the extent you are stuck with a cost of borrow, it would reduce this riskless return, but if you set up a securities lending account and get paid to lend your long CRF position, you can recoup a fair amount of this.


I view this as an extremely attractive arb made more attractive by monthly (as opposed to quarterly or annual) distributions.  The only risk to this trade is if the premium crashed all the way to a discount between the time you reinvest a distribution and the time you sell the new shares.  a) This is highly unlikely; and b) because distributions are monthly, you will never have significant capital at risk.


Shorting for low/no cost:

Derivations on the risk free arb trade clearly can be employed as you can use the right to reinvestment from the long as a way to put on the short in a low/zero cost fashion.  For example, at today’s 94% premium, you could short 1.94 shares for every 1.00 share you are long and by reinvesting the long distribution at NAV and selling at market, you perfectly cover the cost of being short.  This requires more attention (monthly rebalancing) than other structures because the hedge ratio changes with the premium.  To me, this is the ideal way to short this position because it allows you to put on just as much of a position but it takes the biggest problem out of the short, which is paying the distributions created by the borrow.


Another way to de-risk the trade is to take the above hedge ratio and add on an S&P 500 short.  This isolates the premium and the manager’s skill (or lack thereof) and takes out a lot of market risk.  This would be structured as 1.94 CRF shares short, 1.00 CRF share long, and enough S&P 500 long to match 0.94 shares of CRF.  In essence, this creates a 1.94 long/1.94 short set-up where the cost of the distribution owed by the short is offset by the long and the risk of a strong bull market is minimized by boxing the position with a combination of CRF itself and S&P 500.  We have basically isolated the manager’s skill (or lack thereof) and the premium.  To the extent that CRF’s NAV continues to underperform the S&P 500 or if the premium declines, it is accretive to our position. 


A final choice would be to go long CLM and short CRF on the basis that performance will be similar but that CLM is valued at half the premium of CRF.  I think the other structures are superior to this.


I have chosen to go the low cost short (1.94 short CRF: 1.00 long CRF) route since I not only want to capture the premium but I like having some hedge against a bear market.


The primary limitation is that the size of these is capped by the small market caps of CRF and CLM and the spotty ability to get borrow (though it is out there; I found some more this a.m.).  In the two situations outside of the “Riskless Arb”, there is a risk that the premium continues to increase.  For the Riskless Arb, an increase in the premium actually benefits you (the longer and more it persists, the better).


The catalysts are for premium collapsing:

-         continued payment of equity capital rather than income as distributions;

-         continued poor relative performance;

-         poor absolute performance/sharp market correction;

-         SEC crackdown on these sorts of distribution policies.


- continued payment of equity capital rather than income as distributions;
- continued poor relative performance;
- poor absolute performance/sharp market correction;
- SEC crackdown on these sorts of distribution policies.
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