How Effective Is Arbitrage of Foreign Stocks? The Case of the Malaysia Exchange-Traded Fund

Multinational Business Review, Fall 2003 by Hughen, J Christopher

ABSTRACT: Unlike closed-end country funds that usually trade at large premiums to the values of their portfolios, exchange-traded funds facilitate arbitrage to prevent their prices from deviating from their underlying values. However, such arbitrage can involve significant transaction costs, which have caused some to question the ability of this arbitrage to reduce premiums. This study examines the premiums on the !Shares Malaysia Fund, which is the only exchange-traded fund that has experienced an extended suspension of arbitrage. The results illustrate the importance of arbitrage in providing the full benefits of international diversification associated with exchange-traded funds that invest in foreign securities.

INTRODUCTION

While exchange-traded funds (ETFs) are popular alternatives to mutual funds and closed-end funds, some investors question whether the share prices of international ETFs observed on domestic exchanges consistently reflect the values of their underlying portfolios in foreign markets. If ETFs trade at premiums, this limits the diversification benefits available to investors.1 The managers of ETFs facilitate arbitrage to prevent premiums from occurring, and the purpose of this article is to describe this arbitrage process and examine its effectiveness.

INTERNATIONAL INVESTING

Over the past 20 years, individual investors in the U.S. have increasingly used the international equity markets to diversify their portfolios. Numerous studies document how the addition of foreign securities to a portfolio allows investors to achieve a higher expected return for a given level of risk (Solnick, 1974; Jorion, 1989).

The average investor is unwilling to open a brokerage account in another country to trade stocks directly on a foreign exchange. Fortunately, there are several ways to achieve indirect exposure to foreign stocks. The first method is to purchase shares in a mutual fund that invests in other countries. While mutual funds are a convenient vehicle for acquiring an interest in a diversified portfolio, they do have some limitations. You can only invest in mutual funds once a day, but active investors want the opportunity to trade throughout the day. In addition, mutual funds are only required to disclose the composition of their portfolio on a semi-annual basis. Thus, it is usually impossible to determine the securities that a mutual fund owns. Also, few international mutual funds invest exclusively in the securities of a particular foreign country; this prevents using mutual funds to make a targeted bet on a country's performance.

Closed-end country funds, which trade on an exchange like listed stocks, address several of the deficiencies of mutual funds. Country funds can be bought and sold during normal exchange hours, and these funds typically concentrate their investments in a particular country or region. However, the market price of fund shares often differs dramatically from the NAV. For example, the median closed-end country fund on December 31, 2000 traded at a premium of -21.6 percent. The fluctuations in the premiums limit the diversification benefits of country funds. Bailey and Lim (1992), Bodurtha, Kim, and Lee (1995), and Chang, Eun, and Kolodny (1995) conclude that closed-end country funds are sensitive to U.S. returns and provide fewer diversification benefits than direct investments.

PREMIUMS AND ARBITRAGE

Why don't sophisticated investors take advantage of closedend funds that trade at prices different from their NAVs? De Long, Shleifer, Summers, and Waldmann (1990) develop a theoretical model of noise traders in financial markets that offers an explanation for this puzzle. If the difference between price and value reflects the sentiment of irrational investors, then sophisticated investors may face impediments to profiting from premiums. The risk caused by fluctuations in sentiment is not diversifiable in their theoretical model because sentiment, which is correlated among irrational traders, affects many asset classes.

Restrictions on arbitrage prevent rational investors from eliminating closed-end fund discounts. Pontiff (1996) has conducted the most extensive analysis of the relation between arbitrage costs and closedend fund discounts.2 he tests the following four factors that affect the cost of arbitrage in a closed-end fund: the difficulty of replicating the fund's portfolio, the fund's dividend payout, the cost of transactions in the fund's shares, and the level of interest rates. The first three of the above factors account for approximately 25 percent of the cross-sectional variation in discounts.

INTERNATIONAL ETFs

An ETF is an investment company that manages a portfolio of assets on the behalf of its shareholders. While the fund's portfolio objective is to match the return on a particular market index, the fund's share price is determined through the trading process on a stock exchange. The portfolio of stocks owned by an ETF, unlike a mutual fund or closed-end fund, is well known by investors because of its passive investment strategy. International ETFs target foreign market indexes. Barclays Global Investors manages 21 such funds that are called iShares (formerly known as WEBS). Each member of the international iShares series attempts to match the return on a MSCI Index for a particular country.