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I’ve written at length about ETFs and the creation/redemption process previously, but there’s a scenario going on right now which highlights an important pitfall that investors need to be wary of. In my previous pieces, I discussed robust ETFs which allow creations and redemptions in kind. That is to say, if you deliver the underlying assets to the trust, its managers create new shares for you, and vice-versa. This is how most ETFs, including the largest, most frequently traded ones, work. It’s a great mechanism, as it had no effect on the existing shareholders of the ETF. However, there are also some ETFs which allow for cash creations, meaning that you can deliver cash to the ETF Trust, its managers will give you new shares, and will then allocate that cash amongst their portfolio holdings (investing it).

Ron Rowland wrote about an interesting scenario that’s going on right now with EGPT – the Van Eck Market Vectors Egypt ETF. The EGPT ETF effects creations and redemptions on a cash basis. The problem arose when Egypt’s markets ceased trading after Thursday, January 27th. At that time, the Fund had roughly $12MM in assets, invested in an underlying portfolio of Egyptian stocks. The next day, Friday, January 28th, the Fund met a request for $12MM in share creations – issuing new shares and effectively doubling the size of the ETF. There was one huge problem: Since creations are done for cash, the Fund was now sitting on a hefty cash position – a cash position that doesn’t change in value when Egyptian stocks rally. Van Eck suspended creations and redemptions as of Monday, January 31st, but the damage was already done. Egypt’s markets have been closed ever since, and the EGPT ETF has been trading higher in anticipation of a rally in Egyptian stocks when their market re-opens later this week. As Barron's noted this weekend:

Equity proxies in the U.S. and London that have kept on trading while the local market was closed, such as the Market Vectors Egypt Index exchange-traded fund (ticker: EGPT), suggest Cairo stocks could jump some 15% from their depressed levels in late January.

Which brings me to the meat of the point here: EGPT is trading at roughly a 15% premium to its Net Asset Value, which is based on the closing prices of the underlying stocks from Egypt’s last day of trading before the halt. (There are actually some stocks that trade in other markets (i.e., Canada) – for those stocks the most recent trading value is incorporated). However, the change in value of the underlying stocks needed to justify such a premium is much more than 15%, because the fund is sitting on a huge cash position. Are you with me so far? Let’s get to some numbers to drive this point home.

Pretend we have a fund (we’ll call it: SCREW) which trades right at its Net Asset Value – $10 – and has 1MM shares outstanding. The $10MM of assets are invested in the target index, and the NAV of the fund will rise and fall with the value of the underlying stocks. Now, suddenly, Charlie Cash comes in and, via the magic of cash creations, gives our ETF manager another $10MM, and receives 1MM newly created SCREW shares (remember – this is not how most ETFs work, but it is how EGPT works).

However, trading in the underlying index is halted, so now our fund is holding $10MM in shares of the underlying index, and $10MM in cash. When the market reopens, if the market is up 15%, the NAV of our fund will only increase by half that amount! Our $10MM in cash is still $10MM, and our $10MM in stocks rallies to $11.5MM. Total assets: $21.5MM, with 2MM shares outstanding –> NAV = $10.75, an increase of 7.5%. By allowing cash creations when the underlying cash couldn’t be deployed, the managers of the SCREW ETF screwed their existing shareholders. The newly created shares get a free ride on the coattails of the old shareholders – at the expense of the old shareholders.

What all this means is that, contrary to the Barron's interpretation, the EGPT ETF, trading at a 15% premium to NAV and holding 38% cash (that’s the exact number as of 2/11/11 after Van Eck redeployed some of the cash into other markets that were open for trading), is actually pricing in much more than a 15% rally in Cairo stocks when they reopen. Rounding the numbers, since only 60% of the portfolio is invested in stocks, we’d need a 25% increase in the stock position to get a 15% increase in the Net Asset Value of the fund (25% x 60% = the 15% premium to NAV we are seeing).

The ETF continued to soar Monday, up more than 5% as of this writing. Now, at a 20% premium to NAV, the shares are implying a 33% rally when Cairo reopens! I tried to short EGPT this morning, but was unable to obtain stock to borrow in order to do so.

Postscript: The ETF manager should not have allowed such a sizable cash creation, given that the underlying home market was closed on account of the potential dissolution/overthrow of the government! By allowing the cash creations, Van Eck introduced massive execution risk into their fund.

Source: What Investors in the Egypt ETF Should Know When Markets Reopen