ETF, arbitrage and large discounts

[rngadam]

I’m looking into investing in a ETF (Exchange traded funds), specifically the TWN (Taiwan Fund). However, I’m surprised that it is trading at around 13% discount off the underlying equities. Could someone explain to me why no one has stepped in to do arbitrage (buying the ETF, redeeming for the underlying shares and selling them)?

TWN: http://www.etfconnect.com/select/fundPages/global.asp?MFID=3695

EWT ( iShares MSCI Taiwan Index) on the other hand, has only a discount of a fraction of a percent.

EWT: http://www.etfconnect.com/select/fundpages/etf_funds.asp?MFID=47735

Both management fee seem to be about equal (1% for TWN and 0.99% for EWT).

As a buyer, which one should I choose? What factors can explain the large discount on TWN?

[Chairman_Pow]

A google search for exchange traded funds arbitrage didn’t turn up anything useful.

This may help, from the SEC:

Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.

I think it’s fair to say that arbitrage would have been attempted if it’s possible, although I actually don’t have an answer for your question.

[rngadam]

@Chairman Pow

I think it’s fair to say that arbitrage would have been attempted if it’s possible, although I actually don’t have an answer for your question.

Am I right to think that there is some risk to arbitrage since you have to hold blocks of 50,000 units to redeem them to the underlying equities? Wouldn’t this might make it more difficult since it would be hard to purchase over half a million dollars of shares without bumping up the price of the ETF itself significantly? Plus, I’m guessing that there might be some additionnal risk because of the possibly lengthy time before acquiring sufficient shares, redeeming them and selling them?

I’ve also noticed that those with a very large differential with what they track are classified as “closed-end ETF” (-30% to +30%) while “Index ETF” only vary between -1.37% to +1.34%. TWM is the first kind while EWT is the latter… Well, at least I can see there is a difference but I still don’t understand the “why”?

Reading more from this on the same site I linked, I found this:

Unlike Closed-End ETFs, the shares for an index exchange-traded fund can be created or deemed on a daily basis by market specialists. Also, institutional investors can redeem 50,000 share lots in-kind if there is a gap between the net-asset-value and the market price of the fund. These arbitrage opportunities typically create enough demand to minimize the gap between the fund net-asset-value and the fund price.

So I guess closed-end ETF can’t be subject to arbitrage? I think I had both confused and the one I really wanted where index ETF. I still don’t know if one is a better deal then the other tho…

[Chairman_Pow]

@rngadam

Am I right to think that there is some risk to arbitrage since you have to hold blocks of 50,000 units to redeem them to the underlying equities? Wouldn’t this might make it more difficult since it would be hard to purchase over half a million dollars of shares without bumping up the price of the ETF itself significantly? Plus, I’m guessing that there might be some additionnal risk because of the possibly lengthy time before acquiring sufficient shares, redeeming them and selling them?

The important thing to keep in mind is that arbitrage depends on three things:

1. Massive lots

2. Split-second execution

3. Immensly liquid markets

Something else that is important for you or I, but a non-factor for the entities involved is exchange costs/commissions. We’d need to go through a broker, while they pay negligible costs.

So, unless you a) are significantly capitalized (I’m just throwing out a number, but I think in the low millions is a start) and b) have the fastest computer, you’re not going to go too far. The markets where most arbitrage takes place is the forex markets, where there are literally tens of billions of dollars (or equivalents) being traded every day.

In the '70s, it was possible for a single floor trader to make a living by arbitrage between the CBOT and Midam grain contracts (for example). Once computers and the big commercial traders entered the markets (especially banks in the case of forex), the poor floor guy’s been getting beaten up ever since. Arbitrage is generally done by specialized firms who, as I understand it, literally flood the market with buy/sell orders that disappear in tenths of a second. 99%+ of these orders disappear without getting executed, only to be replaced the next second with another order.

I haven’t checked the liquidity on these ETFs (or the underlying stocks), but I presume that it’s not enough to make it worth anyone’s time. As you pointed out, purchasing in the amounts needed to successfully attempt this would cause someone to take notice. Of course, if you trigger the stops on a fund…maybe it would work in your favor, but for arb purposes, holding the securities for that amount of time would be poor judgement.

Well, at least I can see there is a difference but I still don’t understand the “why”?

I’ve done my best, but I’m afraid I can’t help with that part.

So I guess closed-end ETF can’t be subject to arbitrage? I think I had both confused and the one I really wanted where index ETF. I still don’t know if one is a better deal then the other tho…

The interesting thing about an ETF is that the purchaser has a lot more leeway in entering or exiting positions than with a mutual fund, but your Taiwan fund has some remarkably large swings from year to year. Unless you’re planning on using your market timing skills, I’d stay away. While the ITD return is acceptable, I’d get an ulcer watching it tank around like that.

[rngadam]

@Chairman Pow

Unless you’re planning on using your market timing skills, I’d stay away. While the ITD return is acceptable, I’d get an ulcer watching it tank around like that.

Well, to tell the truth, I’m expecting and waiting for a huge downswing before October due to various events I see in my crystal ball. I just thought I’d be prepared and investigate what Index ETF I can take advantage of if and when the TAIEX gets kicked down a notch.

[Chairman_Pow]

@rngadam

Well, to tell the truth, I’m expecting and waiting for a huge downswing before October due to various events I see in my crystal ball. I just thought I’d be prepared and investigate what Index ETF I can take advantage of if and when the TAIEX gets kicked down a notch.

Well, it certainly seems that you’re the sort of guy that the ETFs are made for. Good luck!