Sunday, May 10, 2009

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.


Alon said...

If you compare the two over a 1 year timeframe you notice that the significant divergence starts when TRF pays a large dividend in December 2008 (the dividend was half of TRF's value at the time and the stock went down by 50%).

Over the past 6 months TRF is up only 20% compared to RSX up 76%.

Is it possible that the premium to NAV starts to take into account the projected dividend for the year and then will ratchet down again as that dividend is paid?It doesn't seem that RSX pays nearly the dividend that TRF does, which is odd if the underlying securities are the same.


Jim said...

^^^ No, the premium isn't accounting for any projected dividends. If the underlying securities held by TRF are going to pay dividends, but have not yet done so, those expected dividends should be reflected in the corresponding prices of those equities. Such stock price increases would be accounted for in TRF's NAV.

If, on the other hand, the underlying equities have already paid dividends, but TRF has not yet distributed the received dividends, those dividends would be an asset of the fund and would be reflected in TRF's NAV.

TRF is up way more than 20% over the past six months. You are just looking at a performance chart but are not accounting for the massive distribution in December. TRF is probably up well over 100% in the past six months if you account for the distribution.

Jim said...

Also, most of TRF's last distribution was capital gains, not dividend distributions. RSX tracks an index, unlike TRF. TRF changed its holdings and incurred capital gains. Tax inefficiency is another drawback of TRF.

Anonymous said...

Sorry, still not clear on the dividend issue. Why has TRF consistently paid much much higher distributions than RSX? Most of the holdings are the same (Lukoil, Sberbank, Gazprom etc.) should the distributions look the same? Or is TRF being so actively traded that there are trading gains (seems unlikely?)

Jim said...

^^^ RSX tracks an index. TRF, on the other hand, is actively managed and does not track an index. So TRF buys and sells far more often than RSX, incurring capital gains in the process which must be distributed to the shareholders. Those large distributions in recent years by TRF are primarily capital gains distributions, not dividends. The distributions by RSX are primarily dividends. That is why the distributions from TRF have been so much larger in recent years than those of RSX.