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Arbitrage Alert! Closed-End Funds At Divergent Valuations

Summary BME and THQ are closed-end funds with similar investment objectives and portfolios which have been well correlated historically. The funds are currently trading at wildly divergent premium/discount valuations. Long/short traders should consider a pair trade of long THQ, short BME. BME has filed for a secondary offering of shares that represents more than 20 days’ volume, adding further downward pressure to that fund. As any investor even moderately familiar with the world of closed-end fund (CEF) investing knows, funds rarely trade at net asset value. Funds’ market-determined prices can be at a premium to – or more frequently, a discount to – net asset value (NAV). Theories abound about why the market tends to “love” or “hate” funds at a given time. However, to state the obvious, the market tends to feel similarly about similar funds. For instance, currently, the market hates funds that focus on high yield bonds, while favoring funds that focus on lower yielding, higher quality bonds. As a result, premium/discount arbitrage can be tricky since it creates risk that the market proves correct in its love and hatred of different categories of funds (hint: the market is often quite wrong). Currently, however, there exists an interesting arbitrage pair trade between two similar biotech funds, BME and THQ, which exist on opposite ends of the market’s love/hate continuum. Similar Funds BlackRock Health Sciences Trust (NYSE: BME ) is a well established, non-diversified fund which focuses on healthcare equity investments, with an option writing overlay for added income. From the sponsor website: BlackRock Health Sciences Trust’s (the ‘Trust’) investment objective is to provide total return through a combination of current income, current gains and long-term capital appreciation. The Trust seeks to achieve its investment objective by investing, under normal market conditions, at least 80% of its assets in equity securities of companies engaged in the health sciences and related industries and equity derivatives with exposure to the health sciences industry. The Trust utilizes an option writing (selling) strategy to enhance dividend yield. Tekla Healthcare Opportunities Fund (NYSE: THQ ) is a younger fund that was launched by Tekla just over a year ago to focus on a similar segment of healthcare-related equity investments. From Tekla’s website: Tekla Healthcare Opportunities Fund (“THQ”) is a non-diversified closed-end fund traded on the New York Stock Exchange under the ticker THQ. THQ employs a versatile investment strategy with broad access to opportunities within 11 sub-sectors of healthcare and has the ability to invest across a company’s full capital structure. While there are some differences in scope, (BME uses option writing while THQ has been active in convertible debt), the two funds are remarkably similar in their asset allocations, in some cases making major investments in identical equities [Biogen Inc. (NASDAQ: BIIB ), Celgene Corporation (NASDAQ: CELG ), Bristol-Myers Squibb Company (NYSE: BMY )] and in others choosing close competitors. Source: cefconnect.com, Fund SEC filings Unsurprisingly, given the similarity in holdings, the funds’ net asset values have generally moved in lock-step, with a correlation of daily NAV changes of 0.94 ( source: Convergence Investments analysis) during the past 12 months. (click to enlarge) Source: Yahoo! finance Divergent Valuations Despite the funds’ quite similar portfolios and NAV performance, the market is (currently) valuing the funds quite differently. As of closing on 8/18, THQ traded at -10.5% discount to NAV while BME traded at a 8.1% premium , implying that BME investors are willing to spend 21% more for a similar basket of investments. BME Premium/Discount YTD (click to enlarge) THQ Premium/Discount YTD (click to enlarge) Source: cefconnect.com The Trade While 10% discounts or 8% premiums are both within the range of normal for closed-end funds, the simultaneous existence of both in similar funds is quite rare. The trade implied by this temporary market mispricing is fairly straightforward. Long/short investors should consider long THQ, short BME. Given the funds’ high cross correlation and relatively similar beta risk (BME: 0.63, THQ: 0.69, source: Convergence Investments analysis ), it would not be unreasonable to use 1:1 ratio for a market neutral position. Long-only investors considering investment in BME should strongly consider the alternative of THQ and those with current positions in BME may consider rotating into THQ. I should note, however, that my firm takes no view for or against the healthcare sector so long-only investors should consider their attraction to sector exposure in addition to the many other factors to consider regarding suitability for any investor’s unique circumstances. A Potential Catalyst Finally, Blackrock’s BME fund recently filed definitive materials with the SEC on 8/12/15 for a 453,000 share secondary offering. While the share distributors will undoubtedly seek to sell into the market gradually, this share count is more than 20x average daily volumes so is likely to introduce some downward pressure, especially if share distributors see narrowing premiums. Disclosure: I am/we are long THQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Also, currently short BME. Convergence Investment Management may recommend various securities included within this article for inclusion for individual client portfolios. These recommendations may change at any time and are specific to the individual client’s objectives and risk tolerance.

2 ETFs To Hold For The Next 25 Years

The Dow Jones Industrial Average ETF may be a better way to invest in the American economy than the S&P 500. The Dow Jones Industrial Average typically outperforms the S&P 500 over longer periods of time, especially when dividends are factored in. The Russian stock market is one that investors typically fear, but there is reason to believe that this may be one of the best assets to own going forward. Russia currently has one of the cheapest stock markets in the world and trades at the low-end of its historical valuation range. The Russian market is projected to outperform all major markets in the world going forward, once commodity prices recover. For many investors, investing in exchange-traded funds (also known as ETFs) makes much more sense than purchasing individual stocks. This is because the ETF includes many different stocks that allow one to effectively diversify away company-specific risks while still allowing that investor to profit off of a given theme. In this article, we will examine two ETFs that could easily deserve a position in any investor’s portfolio and that will likely prove to be very profitable holdings over the next 25 years. SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) The Dow Jones Industrial Average has been one of the most widely followed indicators of overall stock market activity for more than a century. The index is composed of thirty stocks that the publishers of the index, currently S&P Dow Jones Indices, believe best represent the composition of the United States economy. Unlike most of the other major stock market indices, the Dow Jones Industrial Average is a price-weighted index. This means that companies with higher stock prices such as Apple (NASDAQ: AAPL ), Goldman Sachs (NYSE: GS ), and International Business Machines (NYSE: IBM ) make up a larger portion of the index than companies with lower stock prices such as Coca-Cola (NYSE: KO ) or General Electric (NYSE: GE ). Unfortunately, this also results in these companies’ stock performance having an outsized impact on the performance of the index that may be completely disconnected from their respective market caps. For example, the stock price performance of Goldman Sachs has a 75% greater influence over the index’s performance as Apple’s stock price performance, despite Apple having a market cap more than six times greater. Given these problems with price-weighted indices, one may wonder why I am suggesting an investment in the Dow Jones Industrial Average instead of a broader, market capitalization-weighted index such as the S&P 500. Well, the reason is that the Dow Jones Industrial Average has historically outperformed the S&P 500. This is immediately apparent when we compare the performance of the SPDR Dow Jones Industrial Average ETF to that of the largest ETF tracking the broader Standard & Poors 500 Index, the SPDR S&P 500 ETF (NYSEARCA: SPY ). Here is how the two ETFs have performed over the past ten years: SPY data by YCharts As this chart shows, the S&P 500 ETF outperformed the Dow Jones Industrial Average over the past ten years (although for much of that time, the Dow Jones Industrial Average was outperforming the S&P 500). But, this comparison excludes one very critical factor. The Dow Jones Industrial Average is by and large composed of mature, slow-growing companies that pay out a portion of their earnings to investors in the form of dividends. While the S&P 500 Index does include companies like this, it also includes a number of younger, high-growth companies as well as other firms that for whatever reason choose not to pay dividends. As a result, the Dow Jones Industrial Average typically boasts a higher dividend yield than the S&P 500. This needs to be factored in when determining relative performance. Here is the same chart, this time showing the total return produced by each of the two ETFs over the trailing ten-year period: SPY Total Return Price data by YCharts As this chart shows, the Dow Jones Industrial Average has outperformed the S&P 500 over the past ten years when dividends are factored in (although yesterday’s decline in the Dow brought the two into parity). This outperformance becomes even more pronounced over longer time periods. Here is the same chart showing the total return of both ETFs since the beginning of 1998 (when the Dow Jones Industrial Average ETF was first made available for purchase). SPY Total Return Price data by YCharts As this chart shows, the Dow Jones Industrial Average has significantly outperformed the S&P 500 over longer time periods. It is for this reason that this ETF, and not the one tracking the S&P 500, is my choice for investors interested in making a broad-based bet on the future of the American economy. The SPDR Dow Jones Industrial Average ETF does a respectable job of tracking its underlying index due to the fact that the ETF itself is composed of the same stocks that comprise the index and in relatively similar weightings. Here are all of the ETF’s holdings, sorted by weight: (click to enlarge) Source: State Street Global Advisors As the chart clearly shows, the ETF simply consists of an identical number of shares of each of the companies in the Dow Jones Industrial Average with the relative weightings being determined by the stock price of each company. This is exactly the same way that the index itself is constructed. With that said however, the weighting of each company owned by the ETF is slightly lower than in the index itself due to the fact that the ETF holds a cash position and the index itself does not contain cash. However, the SPDR Dow Jones Industrial Average ETF is still an excellent way for investors to track the index itself. Market Vectors Russia ETF (NYSEARCA: RSX ) At first glance, this may seem to be an unlikely choice for a long-term ETF holding. After all, Russia is a nation that is widely considered to have a high degree of corruption in its business environment, has been economically sanctioned by several Western nations due to recent events in the Ukraine, and is not generally considered to be an investor-friendly place to invest. However, there is much to like here. One of the ratios that can be used to measure the relative stock market valuations present in a nation is the total market cap to GNP ratio. Investing legend Warren Buffett once described this ratio is “probably the best single measure of where valuations stand at any given moment. Using this measure, the Russian stock market is one of the most undervalued in the world. Unfortunately, it can be difficult to obtain accurate GNP information on many countries, but we can calculate the ratio using GDP instead to illustrate this fact. At the time of writing, Russia had a GDP of $2.12 trillion compared to the United States’ $17.7 trillion. Meanwhile, the Russian stock market had a total market capitalization of $380 billion compared to the United States’ $21.88 trillion. Thus, Russia has a total market cap to GDP of 17.9% compared to 123.6% for the United States (lower values indicate a cheaper market). Here is how this compares to other major markets around the world: Source: GuruFocus As this chart shows, the Russian market is only rivaled by Italy in terms of relative valuation. This is very close to the lowest valuation that the Russian market has traded at since it became accessible to investors. Meanwhile, many other markets around the world are near the midpoints or upper ends of their historical valuations: (click to enlarge) Source: GuruFocus This valuation would seem to imply that the Russian market has some of the greatest potential for outperformance going forward. Investment research site GuruFocus performed a complete analysis of the forward return potential present in each country given the historical GDP growth of each of these countries, the dividend payments from each country’s corresponding ETF, and an assumption that each country’s market will revert to its mean valuation. Here are their projections on the returns of each of these markets going forward: Source: GuruFocus As this chart shows, analysts expect the Russian stock market to outperform all other major national markets going forward. However, there are some caveats here. First and foremost, the Russian economy is highly dependent on commodity prices, both energy and metals. As such, the Market Vectors Russia ETF contains significant exposure to energy and commodities companies. As many of you reading this are no doubt aware, commodity and energy prices have fallen significantly over the past year and many analysts expect that prices will be suppressed for quite some time. This has significantly weakened the Russian economy as well as pressured the cash flows and profits at the companies that make up the majority of the ETF’s assets. It is unlikely that either the nation’s economy or corporate profits will recover until commodity prices do and thus it is likely that the ETF will underperform until that occurs. However, I find it unlikely that commodity prices will be depressed over the 25-year period over which this article refers and thus the Market Vectors Russia ETF looks like an appealing investment. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RSX over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I have long positions in S&P 500 tracking index funds, but not in SPY specifically.

White Mountains Insurance Group Is Preparing For A Financial Storm

WTM is slowly selling off its insurance businesses. The insurance industry is not what it once was. The WTM management team is one of the few who are awake to the risks. The CEO of White Mountains Insurance Group (NYSE: WTM ), Ray Barrette, has voiced concerns about the insurance industry and the general economic environment in his management reports over the last several years. Barrette’s comments are often times indirect by referring to the insurance market as highly competitive. Other times his statements are blatant, claiming that low interest rates and highly competitive insurance pricing do not offer insurance companies an adequate return for their risk exposure. He has voiced concerns with government debt, inflation and rising interest rates, which of course could bankrupt an insurance company if these scenarios happened sharply and unexpectedly. The investment management of WTM coincides with Barrette’s viewpoint. WTM has kept its bond portfolio very short term, far more conservative than the industry average. Large cash holdings are always on the books. WTM has also favored insurance lines that are short tail, as long tail lines can take many years for the claims to settle and are exposed to inflation risks. In my opinion, WTM is one of the most conservative and cautious insurance holding companies operating in the insurance space. There are other cautious holding companies, such as Fairfax Financial Holdings (OTCPK: FRFHF ) and Alleghany Corporation (NYSE: Y ), but WTM has them beat in its paranoia. Not only does WTM have shorter term bonds than these other companies, but WTM has been selling its insurance companies off whereas other insurance holding companies have been buying them and trying to consolidate. On July 27th WTM announced its sale of Sirius Group for 127% of its book value in cash. I found this surprising, as this company accounted for nearly half of WTM’s consolidated premiums and was by far its most profitable underwriter, having combined ratios in the 70-80% range. Selling a core asset such as this implies a bleak outlook for the insurance industry. The sale of Sirius Group is not the whole story. WTM is also selling its portion of Symetra Financial Corporation (NYSE: SYA ), of which it owned 17% of the outstanding shares alongside other partners such as Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). After selling Sirius Group and Symetra Financial, only one of its three major insurance companies are still on WTM’s books, and that is OneBeacon Insurance Group (NYSE: OB ). WTM also has several other insurance holdings such as HG Global/BAM, but they’re small compared to what has been sold off. I believe these actions taken by WTM are very wise. The insurance industry has come under a lot of pressure in recent years. The macro environment has interest rates near zero percent interest. In normal times during the last several decades, low interest rates would push insurance companies to charge higher premiums to balance lower investment returns. However, the current state of the world comes with pathetically low rates, high debt both public and private, and irresponsible governments that simply will not operate within a balanced budget. Low interest rates and overpriced bond and stock markets are forcing other investment managers to seek returns elsewhere by invading the insurance space. Because of the new entrants, existing insurance companies cannot raise their prices during low interest rate environments. This is squeezing the profit margins out of the industry in an unprecedented manner. Warren Buffett has recently commented on the poor state of the insurance industry. Buffett stated that insurance has become “fashionable” for investment managers. I can understand his frustration, but I don’t think fashionable is the right explanation. Other investment managers are going into insurance because there are few other places to go with their money. The investment environment is dismal right now, and additional profits from insurance float are seen as a relatively safe way to enhance returns with few other options. WTM is cashing out of the insurance business, and at a premium to book value. This is truly contrarian when the rest of the insurance industry is trying to consolidate through mergers and acquisitions to become more competitive in a crowded industry. WTM is playing it smarter. WTM is accumulating large cash holdings and investing in startup companies, mostly services, that require minimal capital upfront. WTM’s portfolio is slowly being transitioned into a barbell, with a highly defensive cash component, and a small but highly aggressive component composed of start up companies. A barbell such as WTM’s is the best way to play the current macro environment, in my opinion. If deflation sets in, their large cash position will rise in purchasing power and provide many opportunities in an ensuing market correction. If inflation sets in, WTM’s cash will devalue to some extent but at least their insurance exposure will be reduced. Insurance companies could drop substantially in value under a scenario of high inflation and/or rapid interest rate increases. WTM is a very well managed company. I have been a fan for many years. However, I do not own shares of WTM right now because I perceive them to be fairly valued. The premium over book value that WTM is receiving in its sales of Sirius and Symetra is already reflected in the current share price. The share price has risen substantially since the sales have been announced at the end of July. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.