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Profiting From the Difference

Gregg Greenberg

08/10/04 - 09:40 AM EDT

Investors often confuse exchange-traded funds, or ETFs, and closed-end funds, or CEFs, but arbitrage opportunities and their potential profits abound for those who can understand the differences between the two types of funds.

Closed-end fund shares are listed on securities exchanges, actively managed and trade intraday on the open market. They typically trade in relation to, but independent of, their underlying net asset values, or NAVs. That means that unlike open-end mutual funds, shares of closed-end funds can trade at premiums or discounts to their underlying NAVs.

For example, the Spain Fund(SNF - Cramer's Take - Stockpickr) is a closed-end fund currently trading at $10.51, or a 25% premium to its $8.47 NAV. The Spain fund looks to appreciate by investing primarily in stocks traded on the Madrid market. The average premium for the shares over the past 52 weeks is 12.7%, about half the current level.

In the other corner, ETFs also represent a basket of stocks and trade freely on an exchange, but they typically track an index and are not actively managed. And unlike closed-end shares where the premiums and discounts can be steep, there is an arbitrage method whereby market specialists and institutions can buy or sell ETF shares to keep their prices as close to the NAVs as possible.

The iShares MSCI Spain Index ETF(EWP - Cramer's Take - Stockpickr), which tracks stocks traded in Madrid, for example, had a recent market price of $27.27, offering only a slight 0.26% premium to its $27.20 NAV.

At this point, the connection between the two funds should be apparent -- as should be the arbitrage opportunity, based on the wide spread between the premiums of those different styles of Spanish shares.

If the underlying portfolios of the Spain Fund (CEF) and the iShares MSCI Spain Index (ETF) are the same, or even close in composition, then you should be able to make money exploiting the spread. How? By selling short shares of the closed-end Spain fund and using the money raised to buy a proportional amount of the Spanish ETF.

Sketches of Spain
Portfolio Weightings
Stock Spain Fund%
(CEF)		 iShares MSCI Spain Index %
(ETF)
Telefonica 14.56 23.51
Banco Bilbao Vizcaya 11.50 11.47
Banco Santander Central Hisp. 10.24 13.61
Repsol 7.98 5.01
Endesa 4.38 5.05
Banco Popular Esp. 4.17 4.41
Gas Natural Grp 2.96 2.19
Total: 55.79 65.25
Source: Morningstar, The Spain Fund (6/30/04)

Or in other words, if premium on the Spain Fund's shares falls from 25% to the average of 12.7%, then you'll have a return of more than 12% on your short trade. Meanwhile, the risk that Spanish shares will unexpectedly rise will be offset by the purchase of the ETF for protection.

"As the discount narrows, you get outperformance vis-a-vis the index fund," says Michael Porter, ETF specialist at Lipper.

Which brings us back to the important question: What's in those two baskets of stocks?

It turns out that they are very similar in composition (see chart on prior page). Seven of the top 10 holdings in the Spain Fund can be found in equivalent proportions in the Spanish index ETF. And because of the relatively limited number of stocks trading on Spanish markets, the high concentration of the two funds -- the top 10 holdings account for 70% of the assets -- lessens the chance of a single stock's performance significantly affecting one fund and not the other.

Other arbitrage opportunities might present themselves if, in a similar way, you can pair up a closed-end fund and a comparable ETF.

Porter says the closed-end Brazil Fund(BZF - Cramer's Take - Stockpickr) is a possible arbitrage play. It trades at a 13.5% discount to its NAV and there is a potential match-up in the iShares MSCI Brazil ETF(EWZ - Cramer's Take - Stockpickr). And back in Europe, he suggests investors look at the closed-end New Germany Fund(GF - Cramer's Take - Stockpickr), which is trading at a discount of 16.8%. In this case, the iShares MSCI Germany ETF(EWG - Cramer's Take - Stockpickr) would be the corresponding ETF to buy.

But before doing anything, be sure to review the underlying assets held in the two funds to make sure they are comparable. Knowing the differences between closed-end funds and exchange-traded funds might make you money, but not knowing what you are buying in any financial products will always make you a loser in the end.