Shorts Aren't a Good Fit for Foreign ETFs

Many single-country ETFs trade at premiums, but that doesn't mean they're good shorts.
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Single-country funds dominate the list of exchange-traded funds trading at premiums to their net asset values. But ETF investors looking for international exposure, take note: Just because the share price of an ETF is more than the sum of its parts doesn't mean it's an ideal short sale candidate.

As of last week, 17 of the 25 ETFs with the highest premiums were iShares MSCI indexed country or region funds. (

Barclays Global Investors

, the bank behind the iShares name, has a near monopoly on country funds, which are ETFs that track foreign indices.)

Topping the list were the

iShares MSCI South Korea Index Fund

(EWY) - Get Report

and

iShares MSCI Malaysia Index Fund

(EWT) - Get Report

, which were trading at premiums of 1.06% and 0.96%, respectively.

The average premium for the 17 international ETFs on the list was 45 basis points, with the

iShares MSCI Spain Index Fund

(EWP) - Get Report

coming in at No. 17 with a 21-basis-point premium.

Since one of the advantages of ETFs is the ability to sell them short, one might believe that traders would pounce on these imbalances like hungry wolves on a T-bone steak. But Christine Hudacko, spokeswoman for Barclays Global Investors, cautions retail investors against attempting to capture that difference over the net asset values, or NAVs, because it tends to be erased as quickly as it arrives.

"Premiums and discounts between share price and NAV can occur if there is an imbalance of market supply and demand for an ETF," says Hudacko. "But the creation and redemption mechanism provides a natural arbitrage that should realign any material deviations between the ETF's price and NAV."

She adds that even larger discounts are not unusual and are based on U.S. investor sentiment toward the underlying foreign market, which may be closed during U.S. market hours.

"Non-concurrent trading hours, foreign exchange movements, local market holidays, and foreign government intervention can compound price differences between NAV and share price," says Hudacko. "For example, breaking news released during the U.S. trading day when underlying markets are closed can contribute to share price movement away from NAV. This is known as price discovery."

An example of how time-zone differences affect the price of an ETF can be found with the

iShares MSCI Japan Index Fund

(EWJ) - Get Report

, which recently was trading at a premium around 0.37%. When the Japanese exchange closes at 3 a.m. EST, the NAVs for Japanese stocks in the fund are calculated using closing security prices from local markets as well as Reuters foreign exchange rates taken at 4 p.m. London time.

Because the Japanese share prices are frozen when trading begins on the

NYSE

at 9:30 a.m. EST, the iShares Japan Index Fund spends the day trading on new economic and political information, causing its share price to deviate in value from its underlying NAV at times. That's because the ETF shares trade independently in the U.S., while the underlying shares remain unchanged until Japanese trading resumes.

Unfortunately for arbitragers, the unique structure of ETFs makes it extremely difficult to exploit even slight differences between an ETF's price and its NAV. Unlike mutual funds, which are priced once a day at the 4 p.m. EST close, ETFs are continuously priced throughout the day, effectively wringing out arbitrage opportunities that may arise due to stale pricing.

Furthermore, the market makers who create and redeem ETFs have an additional mechanism for squeezing excessive discounts or premiums out of the share price. If an ETF is trading at too steep a premium, the market maker can drive down the price by selling those ETF shares -- or, in other words, increasing supply -- and exchanging them for shares of the underlying stocks.

The inability of market timers to capitalize on stale prices has made single-country ETFs a popular alternative to international open-end mutual funds. The mutual fund scandal a few years ago revealed market timers were in some cases illegally dipping in and out of mutual funds, hoping to profit from anticipated short-term market moves. Because of time-zone differences among international stock markets, market timers frequently targeted funds holding foreign stocks whose prices were stale.

Closed-end fund specialists, however, still do their best to try and squeeze out profits by gaming the premiums and discounts of closed-end funds to their NAVs.

Although the hurdles are higher for those trying to profit from the ETF pricing discrepancies, Ronald DeLegge, publisher of ETFGuide.com, says there are still opportunities for clever traders.

DeLegge cites a study done by a pair of economists in 2002 that indicated that international ETF quotes were, on average, revised only once an hour -- with the median interval between trades being 25 minutes.

"They also found that it took several hours, and in extreme cases several days, for larger premiums to disappear in international ETFs," says DeLegge. "I suppose a trader, if savvy and patient enough, could find these opportunities."