The Dangers of Buying on Disasters

Charles Wallace wrote an intersting story for Daily Finance about the risks of buying ETFs on disaster news. He specifically looked at ETFs that focused on the Japanese and Egyptian equity markets.

Wallace quotes me in the article saying you shouldn’t put a lot of money into these kinds of ETFs and to make sure you’re diversified. However, a lot of my insights from our interview didn’t make it into the article, especially about the iShares MSCI Japan Index Fund (EWJ) and the main Egypt ETF, the Market Vectors Egypt Index (EGPT). Shares of Egyptian stocks, and hence the Egypt ETF were driven down by protests against President Hosni Mubarak.

Wallace wrote “Trading in the EGPT was brisk in the U.S., and the ETF moved consistently higher even though the stock market in Egypt was closed for more than a month. When the Egyptian Exchange reopened on Tuesday, stocks dropped 10% and EGPT opened at $15.86, a decline of 17% from its March 9 high.”

Anytime an ETF tracks a foreign country, especially one whose market is closed during U.S. trading hours, it can move on news that occurs after the foreign market closes. This typically puts the ETF’s price at a premium or discount to the underlying stocks in the portfolio. However, nearly every time, the movement of the ETF correctly predicts the movement of the local market when it finally opens the next day. So, these premiums or discounts last less than 24 hours. While there is some risk in these kinds of trades, the ETFs usually seem to be doing the price discovery for the closed local market.

However, when a market is closed like the Egyptian market was for a month, then the ETF begins to trade like a closed-end fund. That’s because the arbitrage mechanism that balances out the creation and redemption of the ETF’s shares is unable to work. At that point, the price discovery mechanism is dismantled and the ETF shares can trade dramatically far from the actual value of the underlying stocks in the portfolio. Without the arbs there to keep the share price closely linked to the underlying portfolio, it ceases to trade on fundamentals and becomes pure speculation.

Conclusion, if the ETF can no longer buy the underlying shares of the market it tracks, stay away. You are playing with fire and bound to get burned.

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