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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. Scalper1 News
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