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Arbitraging 20% As An Exuberant Closed End Fund Returns To Normalcy

Summary ETFs and CEFs that track emerging market economies are often popular with foreign investors because they mitigate some risks of owning foreign equities such as accessibility, liquidity and local governance. However, emerging economies often have substantial risks that cannot be priced out by convenience, so these funds usually trade at a discount to their NAV. Occasionally, irrational exuberance will elevate an ETF or CEF above its NAV, creating an arbitrage opportunity. The CEF CUBA has been steadily returning to normalcy after a zealous run following President Obama’s Cuban Diplomacy announcement; ~20% profit potential is still on the table. Business As Usual Exchange traded funds (ETFs) and closed end funds (CEFs) are convenient – one can buy a single asset and have a basket of exposure. ETFs and CEFs can be especially useful when they track foreign stock markets. They can mitigate a host of risk factors, such as accessibility to a foreign stock market, the liquidity of foreign equities, and local governance’s barriers to entry for foreign capital. (Sourced from Google via Barclays ) While ETFs and CEFs can neatly catalog foreign equities into a convenient bundle, risks inherent to emerging markets remain. Currency woes, inflation battles, corruption – the list isn’t a short one. Therefore, it is rather common for ETFs and CEFs to trade at a discount to their net asset value (NAV). This is a combination of risk premium as well as management and expense fees. Typically the spread between a fund’s NAV and its tick price – its discount/premium – is fairly constant. EM risk factors and management fees are generally sticky, so there isn’t much reason for the spread to fluctuate. However, an exogenous event can distort the discount, even turning it into a premium. This creates potential arbitrage opportunities. Business Is… Unusual Three and a half weeks ago, President Obama ordered a return to full diplomatic relations with Cuba. While a significant departure from the decades old stalemate, significant hurdles remain. In particular, the 54-year-old trade embargo remains. (Source: Daily Mail UK ) This highly unexpected event ignited an energetic rally in any equity with even loose ties to Cuba or the Caribbean. The Herzfeld Caribbean Basin Closed End Fund (NASDAQ: CUBA ) was one such beneficiary. At one point, it traded nearly 50% above its NAV. Now that the political reality is beginning to sink in, CUBA’s premium has seen a steady reduction. However, it is still trading well above a rational value and the spread can be approximately arbitraged out, creating a nearly risk-free investment. The Nuts And Bolts Despite its suggestive ticker, the CUBA CEF is not relegated to Cuban assets (something that would be nearly impossible); in fact, it isn’t even meant to mimic the Cuban economy in particular. To quote from the fund management’s website : The Herzfeld Caribbean Basin Fund’s investment objective is long-term capital appreciation. To achieve its objective, the Fund invests in issuers that are likely, in the Advisor’s view, to benefit from economic, political, structural and technological developments in the countries in the Caribbean Basin, which consist of Cuba, Jamaica, Trinidad and Tobago, the Bahamas, the Dominican Republic, Barbados, Aruba, Haiti, the Netherlands Antilles, the Commonwealth of Puerto Rico, Mexico, Honduras, Guatemala, Belize, Costa Rica, Panama, Colombia and Venezuela. The fund invests at least 80% of its total assets in a broad range of securities of issuers including U.S.-based companies that engage in substantial trade with, and derive substantial revenue from, operations in the Caribbean Basin Countries. Since the fund’s investment scope has a loose mandate, let’s see what some of the actual assets are: CUBA Top 25 Holdings Company Ticker CUBA Weight Country Copa Holdings CPA 8.46% United States MasTec Inc MTZ 6.28% United States Coca-Cola Femsa SAB KOF 6.03% Mexico Royal Caribbean RCL 5.34% United States Seaboard Corp SEB 5.17% United States Lennar Corp LEN 4.80% United States Norwegian Cruse Line Holdings NCLH 4.01% United States Banco Latinamericano de Comercio Exterior BLX 3.96% United States Carnival Corporation CCL 3.80% United States Consolidated Water Co CWCO 3.71% United States America Movil AMX 3.44% Mexico BanColombia CIB 3.34% Colombia Watsco Inc WSO 3.24% United States Grupo Televisa TV 2.94% Mexico Chiquita Brands International CQB 2.77% United States Freeport-McMoRan Inc FCX 2.69% United States Fomento Economico Mexicano FMX 2.67% Mexico Cemex CX 2.26% Mexico Steiner Leisure STNR 2.24% United States TECO Energy TE 2.15% United States Norfolk Southern Corp NSC 1.87% United States Wal-Mart de Mexico OTCQX:WMMVY 1.62% Mexico Tahoe Resources Inc THO 1.48% Canada Fresh Del Monte Produce Inc FDP 1.35% United States Atlantic Tele-Network Inc ATNI 1.32% United States (Source: Morningstar ) The above table represents 86.94% of the closed end fund. Fund Insiders Sell Millions Fund insiders were clearly aware of their good fortune – it’s not every day that one’s holdings start to trade nearly 50% above their intrinsic value! Consider the chart below of insider disposals charted behind CUBA’s adjusted close price: (click to enlarge) (Chart created by author; data from SEC , NASDAQ and Yahoo Finance ) The above transactions add up to nearly $4,000,000 of equity disposals. CUBA is worth around $28 million now, so the disposals were of an meaningful magnitude. In fact, with around 3,700,000 common shares outstanding, insiders sold nearly 8% of the entire float. Those transactions were the only sales by insiders in the last 12 months. The Fun Isn’t Over While the boat may have sailed on the astronomical overvaluation of a few weeks ago, there is still plenty of juice left for a mean reversion trade (or for a nearly risk-free approximate arbitrage). The CEF still trades ~11% above its NAV, and that’s cream waiting to be scraped off the top. However, it is entirely reasonable to expect the potential profit to be closer to 20%. Over the past 3 years – including the data distorting recent spike – CUBA has traded at an average discount of 8.70% to its NAV. Over the past six months – inclusive of the recent spike, again – the average discount has been 8.76%. ( Source ) (Source: CEFConnect ) It is reasonable to expect an eventual reversion to the historical discount rate yielding a potential profit of ~20%. Let’s discuss why. Plus Ca Change, Plus C’est La Meme Chose Emerging market funds, whether bundled as an ETF or a CEF, typically trade at a discount to their NAV because of risk premia and management fees. The most recently reported fiscal year saw CUBA with a reported total expense ratio of 2.46%. ( Source ) General risks to emerging market funds apply: currency risks, inflationary tendencies, payments on foreign debt, and corruption, to name a few. Many of CUBA’s holdings are readily accessible for retail investors because they trade either: directly on American exchanges, as ADRs on American exchanges, or OTC. There is no meaningful reason for CUBA to continue to trade above its NAV. The premium is totally resultant from irrational exuberance relating to President Obama’s announcement and traders buying into an investment vehicle that is (superficially) related to the geopolitical news. This is clearly evident when comparing the CEF to its NAV over a long time frame. (Source: Morningstar ) This is not to say that premiums do not occur “often” in CEFs. It is rather regular for eager bidders to push CEFs above their NAV after some unexpected bullish event has occurred. What history tells us about moments like that, though, is that the funds return to their historical trading pattern of NAV discounting because the underlying factors, mentioned earlier, motivating the spread have not changed. Exciting news doesn’t change finance fundamentals – there is no practical reason for an asset to continue to trade above its NAV for an extended period of time – it simply changes the flow of buyers and sellers, which can create a short-term dislocation between ordinary price relationships. How To Play It If one is confident in the continuation of the historical financial relationships such as the ones discussed here, then shorting CUBA is sufficient to manifest that investment view. That would be a mean reversion play and is de facto volatility selling. It makes sense for this situation, considering the recent bout of volatility was caused by an unexpected political event. If one wants to try to arbitrage the relationship, then one would have to buy an approximate basket of weighted equities that CUBA holds and short sell CUBA. Throughout the article I have been saying things like “approximate arbitrage” rather than just arbitrage – that is because there are practical limitations to achieving a pure arbitrage here. While using a mirrored basket of equities limits “risk” in a sense, it is pragmatically problematic and rather cumbersome to do so. One would have to buy ~50 positions and then weigh the individual equities according to the CEF disclosures. To do so correctly one would have to invest a decent chunk of money so as to have a common denominator between individuals positions. There is also the practical problem of information lag – most CEFs report their holdings either quarterly or semiannually. If the fund is actively managed, then one would always have an imperfect basket, regardless of the pains taken to weigh each equity properly. Of course, one could create a basket of Carribbean related assets, and weigh them according to traditional portfolio metrics (as opposed to mirroring CUBA), and assume that the correlation between those two portfolios is “good enough”. In my opinion, short CUBA is “good enough”. Historical norms will return, and CUBA will likely begin to trade at the historical discount of nearly 10% that it has traded at for years. The Opportunity In Summary What happened: Nearly all emerging market closed end funds trade at a discount to their NAV. This relationship is due to EM risk premia and management fees. CUBA is a closed end fund that is currently trading ~10% above its NAV. This premium was recently as high as 50%. The richening of the valuation was catalyzed by President Obama’s announcement of resuming diplomatic relations with Cuba. Expectations: CUBA will return to its historical average discount to NAV of ~8-10%. This leaves about ~20% of juice left in the opportunity. Reasoning CUBA, the CEF, has very indirect exposure to Cuba, the country. This is by no fault of the fund managers – it is nearly impossible (and possibly illegal) to have direct exposure to a communist country that the U.S. forbids nearly all trade with. Therefore, the run up of CUBA was likely a case of benefit-by-association. The political quagmire that is the U.S. congress is highly unlikely to normalize trade relations with Cuba – especially in an efficient manner. This reality will become evident and likely impact Cuba-related equity premiums. Risk premia and relatively high management and expense fees (~2.5% all in) justify a discount to NAV, especially when many of the top holdings in the CEF are easily accessible to U.S. investors. A long CUBA position may be a nice investment one day – basket exposure to the Carribbean is enticing, especially with the long term expectation of Cuban trade with the U.S. However, waiting for the NAV discount to return to initiate such a position is wise, and taking some easy profits while that long-standing relationship returns to normalcy is an appealing opportunity. The downside is nearly non-existent and the upside of 20% makes the opportunity worthwhile. On a closing note, consider this graphic showing emerging market closed end fund discount/premium relationships. See if you can spot the one that’s different. (click to enlarge) (Source: Wall Street Journal ) Additional disclosure: I retain the right to open L/S positions in any equities mentioned.

If You Think You Are Buying Into Oil, Think Again!

Summary Difficulty in finding a spot oil exposure in the market. USO ETF does not mirror oil price movements perfectly. Long dated oil futures might provide better exposure. There is a lot of hype now looking at oil given the large volatile swings in oil price and its overall drastic decline since about a year ago. For savvy investors, this article would probably not be very relevant because you might already know this. Retail investors who read about oil prices in the news and are very new to this should however, take a closer look. The average investor would probably think of going long or short oil via exchange traded funds, namely the United States Oil Fund or USO. Some information on USO ( website ) As of Jan. 13, 2015 Market Capitalization : 1,688 million Assets Under Management: 1,667 million Management Fee: 0.45% Total Expense Ratio: 0.76% (from 9.30.2014 fund update ) According to the USO website, USO is “designed to track the daily price movements of the West Texas Intermediate (“WTI”) light, sweet crude oil”. For retail investors, this is generally a liquid counter with an average of 16.7 million shares traded daily in the past 3 months. Notably, trading volumes seems to have picked up recently perhaps because of the coverage of oil prices in the news lately. As of Jan 13, the daily volume was 33 million shares traded. Caution is Advised If an investor wants to get exposure to Spot Oil prices without renting a vessel to physically store oil, the investor may have a wrong impression that a good way would be to buy or sell the USO ETF units. Here’s why this is quite ill advised. (click to enlarge) Plotting a chart of the USO ETF with the continuous CLc1 NYMEX prices shows a very obvious trend. In 2009, WTI prices rose from $40 to $80 in a year’s time. During the same period, USO ran up from $29 to $39. A very striking difference in the return profile for an investor who wishes to invest in spot oil prices but ends up buying something different. As prices collapsed in the middle of 2014, from about $100 to right now hitting $45, the USO declined from $37 to about $18. This is also slightly less than the CLc1 movement. For those interested in some numbers, I have extracted out the month-end closing prices of both the USO and the CLc1 in the table below. Month USO CLC1 (spot) USO +/- % CLC1 +/- % Jan-09 29.22 41.75 Feb-09 27.03 44.12 -7.49% 5.68% Mar-09 29.05 48.85 7.47% 10.72% Apr-09 28.63 50.88 -1.45% 4.16% May-09 36.41 66.95 27.17% 31.58% Jun-09 37.93 70.6 4.17% 5.45% Jul-09 36.81 69.5 -2.95% -1.56% Aug-09 36.05 69.57 -2.06% 0.10% Sep-09 36.19 70.4 0.39% 1.19% Oct-09 39.31 76.99 8.62% 9.36% Nov-09 39.16 76.42 -0.38% -0.74% Dec-09 39.28 79.62 0.31% 4.19% Jan-10 35.64 72.64 -9.27% -8.77% Feb-10 38.82 79.61 8.92% 9.60% Mar-10 40.3 83.38 3.81% 4.74% Apr-10 41.33 86.22 2.56% 3.41% May-10 34.05 74.09 -17.61% -14.07% Jun-10 33.96 75.37 -0.26% 1.73% Jul-10 35.34 78.99 4.06% 4.80% Aug-10 31.91 71.68 -9.71% -9.25% Sep-10 34.84 79.81 9.18% 11.34% Oct-10 35.14 81.92 0.86% 2.64% Nov-10 36.04 83.59 2.56% 2.04% Dec-10 39 91.4 8.21% 9.34% Jan-11 38.61 92.22 -1.00% 0.90% Feb-11 39.19 96.87 1.50% 5.04% Mar-11 42.58 106.79 8.65% 10.24% Apr-11 45.15 113.42 6.04% 6.21% May-11 40.5 102.59 -10.30% -9.55% Jun-11 37.26 95.12 -8.00% -7.28% Jul-11 37.43 95.86 0.46% 0.78% Aug-11 34.51 88.72 -7.80% -7.45% Sep-11 30.5 78.75 -11.62% -11.24% Oct-11 35.74 92.58 17.18% 17.56% Nov-11 38.78 100.5 8.51% 8.55% Dec-11 38.11 99.06 -1.73% -1.43% Jan-12 37.82 98.28 -0.76% -0.79% Feb-12 40.92 106.91 8.20% 8.78% Mar-12 39.23 102.93 -4.13% -3.72% Apr-12 39.68 104.89 1.15% 1.90% May-12 32.61 86.5 -17.82% -17.53% Jun-12 31.82 84.84 -2.42% -1.92% Jul-12 32.68 87.96 2.70% 3.68% Aug-12 35.89 96.56 9.82% 9.78% Sep-12 34.13 92.1 -4.90% -4.62% Oct-12 31.78 86.01 -6.89% -6.61% Nov-12 32.56 88.94 2.45% 3.41% Dec-12 33.36 91.79 2.46% 3.20% Jan-13 35.28 97.41 5.76% 6.12% Feb-13 33.06 91.83 -6.29% -5.73% Mar-13 34.76 97.28 5.14% 5.93% Apr-13 33.16 93.32 -4.60% -4.07% May-13 32.61 91.61 -1.66% -1.83% Jun-13 34.15 96.49 4.72% 5.33% Jul-13 37.36 105.32 9.40% 9.15% Aug-13 38.48 107.76 3.00% 2.32% Sep-13 36.85 102.29 -4.24% -5.08% Oct-13 34.69 96.24 -5.86% -5.91% Nov-13 33.46 92.78 -3.55% -3.60% Dec-13 35.32 98.7 5.56% 6.38% Jan-14 34.8 97.46 -1.47% -1.26% Feb-14 36.74 102.76 5.57% 5.44% Mar-14 36.59 101.56 -0.41% -1.17% Apr-14 36.32 99.68 -0.74% -1.85% May-14 37.68 102.93 3.74% 3.26% Jun-14 38.88 105.51 3.18% 2.51% Jul-14 36.31 97.65 -6.61% -7.45% Aug-14 35.76 95.84 -1.51% -1.85% Sep-14 34.43 91.32 -3.72% -4.72% Oct-14 30.63 80.7 -11.04% -11.63% Nov-14 25.58 65.99 -16.49% -18.23% Dec-14 20.36 53.71 -20.41% -18.61% Slight percentage variations in price movements can mean quite a lot to investors. Hence, it is better to understand why this occurs before making a decision to invest. Oil futures are currently in a contango, which basically means oil prices in the future, are worth more than the current price. This usually reflects some cost of handling and storage and cost of carry. (click to enlarge) Looking at the difference between a Dec 2015 futures price of $53.32 versus the front month futures price of $45.99, it may be easy for anyone to simplistically try to mirror a hedge strategy by trying to buy the USO and selling the Dec 2015 futures. The problem lies with how the USO is priced. Here is a snapshot of what the USO holds in its Net Asset Value disclosed: (click to enlarge) (click to enlarge) As shown above, as time progresses, the fund rolls over its holdings from the current front month futures (e.g. Feb 15 futures) into the next month (Mar 15 futures). In the process of rolling over its holdings, it sells the Feb 15 futures and buys the Mar 15 futures, hence incurring the differential cost or spread between the Feb and Mar products. In the USO prospectus page 18, this phenomenon is explained and illustrated in the example quoted below. “If the futures market is in contango, the investor would be buying a next month contract for a higher price than the current near month contract. Using again the $50 per barrel price above to represent the front month price, the price of the next month contract could be $51 per barrel, that is, 2% more expensive than the front month contract. Hypothetically, and assuming no other changes to either prevailing crude oil prices or the price relationship between the spot price, the near month contract and the next month contract (and ignoring the impact of commission costs and the income earned on cash and/or cash equivalents), the value of the next month contract would fall as it approaches expiration and becomes the new near month contract with a price of $50. In this example, it would mean that the value of an investment in the second month would tend to rise slower than the spot price of crude oil, or fall faster. As a result, it would be possible in this hypothetical example for the spot price of crude oil to have risen 10% after some period of time, while the value of the investment in the second month futures contract will have risen only 8%, assuming contango is large enough or enough time has elapsed. Similarly, the spot price of crude oil could have fallen 10% while the value of an investment in the second month futures contract could have fallen 12%. Over time, if contango remained constant, the difference would continue to increase.” Conclusion I hope I have driven the point across on the USO ETF, that it is a means to get exposure to oil price movements, but it is nowhere near a perfectly correlated product.

Protect Profits By Implementing A Risk Reduction Strategy

Improve Returns by Staying Out of Trouble. The Importance of Implementing a Circuit Breaker. Is It Working? Back-Testing Issues Explored. Portfolio return and risk are bound together, but there is a way to minimize losses most investors endure in long bear markets of the type experienced in 2008 and early 2009. How does it work? The sample portfolio described below is made up of ten randomly selected dividend aristocrat stocks plus the Vanguard Total Stock Market ETF (NYSEARCA: VTI ), and two treasury ETFs, the iShares 20+ Year Treasury Bond ETF ( TLT) and the iShares 1-3 Year Treasury Bond ETF ( SHY). VTI and TLT are included as references for equity and bond performance levels. SHY is critical as it is the “circuit breaker” ETF. In other words, reduce portfolio draw-down by staying away from securities that under-perform SHY. Investors will populate the ranking spreadsheet with their own holdings. The sample portfolio holds stocks and ETFs for demonstration purposes only. SHY is the exception as it serves as the ranking cutoff ETF. In the sample portfolio below, an investor holding these securities would sell off Johnson & Johnson ( JNJ), AT&T (NYSE: T ), Coca-Cola (NYSE: KO ), and Chevron (NYSE: CVX ) as these four stocks are ranked below SHY based on three metrics (these three metrics are defined in greater detail in prior Seeking Alpha articles ): Performance over the past 91 calendar days. Performance over the past 182 days. Volatility as measured by a semi-variance calculation. The investing model is as follows. Sell securities that are under-performing SHY based on a performance and volatility ranking model. Purchase the top ranked securities. Depending on how much one wishes to concentrate the portfolio the number of securities will vary. I prefer to work with ETFs so I will rank 10 to 15 Exchange Traded Funds and purchase two to five of them so long as they are ranked above SHY. If no securities are ranked above SHY, then hold the cash in a money market or invest in SHY as it is a low volatile security. (click to enlarge) I’m frequently asked, how well does this model perform when back-tested? Any investment model, when back-tested, is prone to all sorts of uncertainty. Here are a few that quickly come to mind. Stocks and ETFs are purchased throughout the trading day whereas back-tests use closing day prices. Price differences over a multi-year study add significant uncertainty into the final performance results. Many investors use limit orders so it may be days before a limit order is struck and there are times when the order is never placed. The start and end dates of a back-test has a major impact on the end performance results. When using ETFs for back-testing, many do not have years of historical data, thus crippling the results. In the above rankings, how many securities are selected for investment? If two work best in the study how can one be sure it will work out best going forward? Many back-tests “over curve-fit” only to deceive the reader. Is the model an anomaly that will disappear as more investors use it? Staying out of trouble has yet to be fully tested as this model has only been operational for less than one year. Nevertheless, the results are positive when working with ETFs that cover broad indexes such as U.S. REITs, Commodities, Gold, International Bonds, U.S. Bonds, U.S. Equities, International REITs, etc. I am tracking the performance of eleven portfolios, each with a different launch date. Each portfolio is reviewed every 33 days and the reviews are scattered throughout the month. Portfolios are analyzed to see if the performance at the end of each week is trending up or down based on the performance six weeks ago. For nearly every portfolio, those trends are positive. While results are reported each week, only trends over many months will answer the question – is this a valid risk reducing model? A “good” bear market will also help to answer the question.