An Arbitrage Strategy for Trading the Templeton Russia & East European Fund

I have previously recommended the Templeton Russia & East European Fund (symbol: TRF) as the best means for small investors to invest in Russian equities. Back when I made my recommendation in 2005, there was no suitable ETF that focused on Russian equities.

However, in late April 2007, the first ETF focused on Russian equities was introduced. The name of the ETF is the Market Vectors TR Russia ETF (symbol: RSX). RSX tracks the benchmark DAXglobal Russia+ Index. According to ETFconnect, the DAXglobal Russia+ Index is comprised of companies with market capitalization greater than 150 million dollars that have a daily average traded volume of at least 1 million dollar over the past six months.

I now firmly believe that as between RSX and TRF, RSX is a far superior investment product. First, RSX has a lower expense ratio (0.69% versus 1.70%). Second, because TRF is a closed-end fund, it will typically trade at a premium or discount to its net asset value (NAV). As I have discussed in the past, TRF typically trades at a premium, but the amount of the premium can vary dramatically. In 2007, for example, the NAV of TRF increased 18.74%, but the share price dropped 1.33% because the premium plummeted over 30% at the beginning of 2007 to less than 10% by the end of 2007.

As of the close of the stock market on Friday, May 8, 2009, TRF had a NAV of $10.56 and a share price of $19.00. TRF therefore trades at a 79% premium above its NAV. That premium is not sustainable and I cannot determine why anyone who pay a 79% premium for TRF when there is a perfectly suitable ETF alternative available, i.e., RSX. I suspect that day traders are bidding TRF up to unsustainable levels. According to the Franklin Templeton website, TRF only has 4.6 million shares outstanding. Given its small float, TRF is a ripe target for momentum investors such as day traders - e.g., because it has so few outstanding shares, small investors may be able to greatly affect the daily price of TRF.

I firmly believe that TRF's premium will eventually disappear and its share price will eventually trade around its NAV, as it has in the recent past. As recently as November 30, 2008, for example, TRF actually traded at a discount of 5.87%!

A potential arbitrage opportunity exists which would allow one to profit from the inevitable decrease in the share premium for TRF. Specifically, by selling short TRF and establishing a long position in RSX, one could effectively profit on the eventually premium compression. RSX and TRF invest in a similar, although not the same, mix of Russian equities. There is a strong correlation between appreciation of TRF's NAV and movements in the share price for RSX.

RSX closed at $20.62 and TRF closed at $19.00 on Friday, May 8, 2009. Based on closing prices, one could generate a hedged position between RSX and TRF by selling short 2062 shares of TRF and purchasing 1900 shares of TRF. If the $8.44 premium of TRF were to shrink or disappear entirely, one would would make a substantial profit after transaction fees.

1989-2008 Annual Returns for Select Developed Markets

The chart below illustrates annual returns between 1989 and 2008 for select developed foreign markets. The chart shows the returns for the various MS country indices for Australia, Canada, France, Germany, Hong Kong, Japan, Switzerland, and the United Kingdom. As references, the chart also includes annual returns (in terms of U.S. Dollars) for the MSCI EAFE Index of foreign developed markets and for the U.S., as represented by the S&P 500 Index.

Many investors invest at least part of their stock market portfolio in foreign stocks, such as emerging markets and/or foreign developed markets. The most widely followed index of foreign developed markets is the MSCI EAFE Index. As I have previously mentioned, the U.S. Dollar will likely continue to weaken over time versus foreign currencies as a result of ongoing budget and trade deficits.

As shown in the chart below, the MSCI EAFE Index provided a meager cumulative return of about 85.70% between 1989 and 2008, an annualized return of just about 3.14%. The returns of the MSCI EAFE Index were dragged down by the abysmal performance of the Japanese stocks. The MS Japan country index had a cumulative return of -39.51%, or an annualized return of -2.48% during the period tracked.

However, strong performances were realized by some of the foreign developed markets. As shown, the MS Switzerland Index realized an impressive cumulative return of about 648%, or about 10.52% per year. Hong Kong was another strong performer, returning about 569%, or 9.98% per year.

Some of the weaker performances were realized by the United Kingdom and Australia. The MS United Kingdom country Index returned a total of about 268%, or 6.74% per year. The MS Australia country Index, on the other hand, returned a total of about 274%, or 6.83% per year.

U.S. stocks performed well in comparison to the foreign developed markets tracked, beating all of the foreign markets tracked except for Switzerland and Hong Kong. The S&P 500 Index returned a total of about 404%, or about 8.42% per year during the period tracked.