The ease of adapting Drach’s methods to closed-end funds is based on the similarity of scanning for relative discounting. The essence of the timing technique is to attempt to expand common stock investment when the overall market is relatively low, confining investment interest to stocks that qualify for the Master List, which appear relatively discounted to the others.
Scanning for the most appropriate closed-end fund based on discounts has the same objective: isolating the cheapest. In Drach’s objectives, he is searching for specific stocks that are overly discounted. In Herzfeld’s closed-end fund analysis, he is searching for the most discounted fund. The focus of both techniques is to isolate excessive discounts relative to historical/statistical norms.
A significant differential between Drach’s concentration on specific stock and Herzfeld’s concentration on specific funds is that the funds, by their structure, involve diversity in the number of different positions. Read the rest of this entry »
Two things must be kept in mind when establishing a long position in this kind of hedge. First, since Treasury bond futures contractsrepresent face value of $100,000 worth of Treasury bonds, the investor will want to go long approximately $100,000 worth of closed-end bondfunds. When it comes to trading closed-end bond funds, I do not recommend buying more than 2000 or 3000 shares of a single fund for a short-term trade. That is why we would go long several different closed-end funds, representing positions of from $31,000 to $34,000 and amounting to approximately $100,000. That $100,000 long position offset the short position of 1 September U.S. Treasury bond futures contract at 100.18, priced at a 7.943 yield.
On February 10, 1978, with the Dow Jones Bond Average down to 89.79, two significant changes had taken place since we established our theoretical long and short positions: (1) The long positions in the bond funds had become profitable, and (2) so had the short position in the Treasury bond futures contract. For example, JHS was selling at 175/8, up from 167A; DBF was up to 165/8 from 161/2; and PAI had gone from 135/8 to 1334. The net asset values of all three funds had declined but the discounts, as predicted, narrowed more than the decline in net asset values, resulting in the profits. Read the rest of this entry »
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. Read the rest of this entry »
