In the common stock investment techniques, the most obvious hedging strategy might be to be long the stocks that are relatively discounted and sell short those that appear most overpriced. However, the process is not so simple.

Because of the composition of the Master List, the stocks as a group tend to do significantly better than the market as a whole. Consequently, although the long positions have significantly outperformed the broadly based market, the short positions, if sold, will likely provide lesser returns than the overall market.

It is because of the Master List’s positive bias that in hedging accounts Drach utilizes writing index call options as a substitute for the short side. This substitution both eliminates the effect of the Master List’s upside bias that would be experienced in attempting to short Master List stocks and provides added profitability for the short side because of premium capture. As discussed in Chap. 9, the method of going long the selected Master List issues and proportionately shorting (selling) index call options is a lethargic process, which has so far produced a constant annualized return of about 15 percent irrespective of overall market conditions.

The hedging limitations resulting from investment considerations confined to the Master List and index call writing can be overcome with closed-end funds because of both the diversity in fund types and the discount function.

FundsA very large number of hedging strategies have been developed by imaginative closed-end fund traders. In this writing we will limit our discussion to the six most popular and easily understood.

1. Buy a closed-end fund selling at an excessive discount, at the same time sell a closed-end fund that is priced at a premium. If a down market carries the first fund’s shares still lower, it will almost surely do greater damage to the premium-priced fund, enabling the short side to cover at a profit that more than offsets the long side’s loss. On the other hand, should the market advance, the excessively discounted fund will likely appreciate more than the fund selling at a premium.

For example, in February 1991 Gabelli Equity Trust was trading at an 8-percent premium to net asset value at 123/4, while another diversified equity fund, General American Investors, was at a 13-percent discount, at a price of 203/4.

By November 4, 1991, Gabelli Equity Trust had declined 21 percent to 93/4 and was trading at a discount of 12 percent to net asset value, while General American had increased by 30 percent to $27 per share and its discount had narrowed to 8 percent.

2. Buy a closed-end fund at an excessive discount, and meanwhile go short on an equivalent proportional amount of individual stocks in the same fund’s portfolio. During a rally, the NAV will rise in direct proportion to the rise in the short positions. However, the long position in the fund will probably outperform the rise in the fund’s stocks as the discount narrows. Should the market fall, because the fund was purchased at an excessive discount, the decline will likely be less than the fall of theindividual stocks shorted.

For example, in September 1991 you could have purchased H&Q Healthcare Fund at 163/4 at an 11-percent discount to net asset value and sold short its largest positions at the prices indicated in Table 10.1.

On November 1, 1991 you could have sold the H&Q, Healthcare position at a 14-percent premium to net asset value at a price of 233/4, a gain of approximately 45 percent, while the short positions created a loss of approximately 6 percent, thereby leaving a net gain of 39 percent.

3. Buy a closed-end bond fund at an excessive discount; sell short U.S. Treasury bond futures, or a combination of U.S. Treasury and corporate bonds. If the bond market rallies and the excessive discount of the bond fund narrows, the long position will generally become more profitable than the short positions. The loss in the shorts will mirror the performance of the overall bond market. But, because of the leverage factor in buying the closed-end bond fund at an excessive discount, it will usually produce a larger profit than the loss on the short position. If the bond market declines, the losses on the short positions will usually be greater than the loss in the bond funds because of the excessive discount at the time of purchase; that is, the discount is notlikely to widen.

A typical closed-end bond fund hedge involving Treasury bond futures would have looked something like this on December 2, 1977, with the Dow Jones Bond Average at 91.91 The following long positions could have been established: 2000 shares of John Hancock Income Securities OHS) with a net asset value of 20.29, a discount of 18.7 percent, and a per-share price of 1614 for a cost of $34,650; 2100 Drexel Bond Fund (DBF) with a net asset value of 20.29, a discount of 18.7 percent, and a per-share price of 161/2 for a cost of $34,650; and 2300 shares of Pacific American Income Shares (PAI) with a net asset value of 15.73, a discount of 13.4 percent, and a per-share price of 165/8 for a cost of $31,377.50. The combination of these purchases amounted to a long position investment of $99,737.50.

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