Profiting From the Difference

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) 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), 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)