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

Multinational Business Review, Fall 2003 by Hughen, J Christopher

The managers of ETFs facilitate arbitrage through the in-kind creation or redemption of shares in large blocks called creation units. If a fund's shares are trading at a premium to the value of the portfolio in the foreign market, institutional investors can implement an arbitrage by creating new fund shares. Before the start of each trading day, the fund company releases a detailed list of the securities that it would need to receive in exchange for a creation unit. This portfolio generally consists of the stocks in the index that the fund tracks. Thus, when the fund's share are trading at a premium, an institutional investor can buy the underlying assets of the fund at a relatively low price in the foreign market, exchange this portfolio for ETF shares, and sell the shares at a relatively high price in the domestic market for a profit.

Institutional investors can also implement an arbitrage to take advantage of ETFs that trade at a discount. This involves purchasing enough ETF shares to form a creation unit and trading them with the fund manager for a portion of the securities that the fund holds in its portfolio. A profit can be realized since the cost of purchasing a creation unit is less than the value at which the fund's assets can be sold.

Various frictions prevent this ETF arbitrage from generating a riskless profit or preventing all fund premiums from developing. First, transaction costs reduce the profitability of arbitrage, and these include brokerage costs, bid-ask spreads, and a fee of several thousand dollars charged by the fund company to facilitate in-kind creations or redemptions of shares. In addition, delays in transferring the securities can impede many investors from taking advantage of premiums. Finally, the underlying assets of international ETFs usually do not trade at the same time as the fund shares in the American market, and this nonsynchronous trading means that premiums are calculated using stale prices. Therefore, a premium does not necessarily reflect an arbitrage opportunity.

Khorana, Nelling, and Trester (1998) examine the index tracking ability of the WEBS for the first six months of their existence. By regressing the daily WEBS return on the daily MSCI Index return, they found the value of the WEBS followed the index value, with an average R2 of 90 percent. However, these results do not exclude the possibility of large premiums occurring.

HYPOTHESES

Some investors have expressed doubts about how effective the arbitrage process is for international ETFs. An article in the Wall Street Journal discusses the views of the former assistant chief counsel of the sec on this subject: "the premium/ discount risk is greatest in international-stock ETFs and is 'being misrepresented' in materials from ETF sponsors and the American Stock Exchange."3

To assess the effectiveness of arbitrage in eliminating premiums, this study examines the only extended suspension of fund-facilitated arbitrage in an ETF. This is accomplished by testing the hypotheses listed at the top of the next column.