Description

Long BTO US / Short IAT US - dollar neutral hedge

The trade is to go long the BTO closed-end fund and to go short IAT exchange traded fund in equal dollar amounts.  The idea behind the trade is that many closed end funds (CEFs) that currently trade at discounts to NAV used to trade at premiums or smaller discounts to their underlying NAVs prior to the stock market rout that started two years ago.  While the market (as measured by the S&P 500) is up 58% from its two-year low on March 9, 2009, and the discounts on many CEFs has contracted, there are some CEFs that still possess large discounts to NAV that have not contracted with the market rebound since March.

With this backdrop I began to look for CEFs that possessed certain characteristics:

• Current discount to NAV of at least 15%
• Not invested in real estate (since value of ultimate underlying assets is illiquid and difficult to quantify)
• Listed on a market in the USA
• Invested in underlying securities that are generally liquid and of large cap companies
• A market capitalization of at least $200 million to provide sufficient liquidity
• Highly correlated with a respective sector ETF

What I was looking for was a CEF that used to trade at a premium, or at least a smaller discount, to its underlying NAV, but now trades at a large discount that has failed to correct with the market rebound.  I wanted this CEF to be liquid and to be invested in large cap companies/liquid securities and I wanted the ability to short an ETF that has a high correlation to the CEF.  I believe such a trade would offer asymmetrical returns: If the market turns down, the downside should be limited as the CEF already trades at a large discount near the historical wide discount, and if the market continues to rebound, the CEF price will (like a value stock) eventually correct.  So little downside with a good possibility of upside.

To find such a CEF I searched the CEFA website, www.closed-endfunds.com, and looked at the funds with the largest discounts.  I eliminated those that were listed outside the U.S. (eliminating a lot of Canadian contenders), as well as those in real estate and illiquid underlying securities and those with market caps under $200 million.  I then looked at the remainder and examined their correlation with a variety of ETFs to find those with a high correlation to an ETF in their respective sector.

The best candidate I found was BTO, the John Hancock Bank and Thrift Opportunity Fund.  BTO is a $300mmm market cap CEF that trades at a 17.6% discount to its NAV.  It is invested in mainly large, liquid financial institutions such as JPM, USB, BK, WFC, as well as many regional bank and thrift equities.  The top 10 holdings account for 47% of the portfolio and the median market cap of the portfolio companies is $5.6 billion.  The average price to book of portfolio companies is 1.05x. 

Its current 17.6% discount to NAV is actually wider than its one year average discount of 16.2% (unlike many of the other CEFs I looked at) so the downside of the trade looks very limited.  And its average discount to NAV during 2007 was 8.2% so there's decent scope for upside if BTO were to return to that average discount. 

In looking at ETFs to hedge against BTO, I found the highest correlation with IAT, the iShares Dow Jones Regional Bank Index Fund ETF.  In using the historical regression function, HRA, on Bloomberg, I found an R-squared of .86, which is one of the highest I found between the CEFs I looked at and their respective ETFs. 

Based on the latest dividend, BTO has an indicative dividend yield of 1.67% versus 1.78% for the IAT exchange traded fund, so there is a negligible dividend loss on a dollar-neutral hedge. 

So the trade is to go long BTO and to sell short and equal dollar amount of IAT as a market hedge.  With the R-squared of .86, the IAT hedge should eliminate most of the market risk.  If the stock market turns south again, the fact that BTO is trading at a discount greater than its one year average means there should be very little or no downside.  In fact, in the past year the discount to NAV has only rarely gone over 20%, and then quickly reverted to below 20% in the following day or two. 

If the market continues its northward march, the BTO discount to NAV should shrink, providing the upside to the trade.  While I cannot explain why BTO has lagged other CEFs in contracting its NAV discount, I offer the explanation that as with value stocks, the market is often inefficient in valuing securities, even closed-end funds.  So the market should eventually correct this anomaly.  After all, closed-end funds are really a bull-market retail product.  And while I don't give it much chance, there's the added (remote) possibility that an activist closed-end fund investor, such as Laxey Partners, could target BTO to convert to open-ended status.  Finally, the fund could purchase its own shares to shrink the discount.

I believe there's little (maybe 3% downside) in the trade worst case, and if the fund returns to its 2007 average discount to NAV in the next year, there's close to 10% upside.  Not a barn burner, but a very safe, hedged trade with an attractive asymmetrical return profile.

Catalyst

Eventual shrinking of discount to NAV from continued market rally (since closed end funds are bull-market retail products) and/or buying its own shares in the market, along with small possibility of an activist closed-end investor agiatiing for a change to open-ended status.  All with minimal downside if market turns down, and negligible carrying costs of trade.