This piece is an enhancement to my previous post about EGPT.
Thanks to Dave Nadig at IndexUniverse for pointing out an essential feature relating to EGPT’s cash creations. Nadig notes that Van Eck, the ETF manager, has a safety valve built into the creation process.
In such cases where the Trust makes Market Purchases, the Authorized Participant will reimburse the Trust for, among other things, any difference between the market value at which the securities were purchased by the Trust and the cash in lieu amount.
In other words, the AP who executed the large cash creation right after Egypt closed their markets should have to remit an additional “make whole” payment to the Trust when the Egyptian stocks open. If the stocks open 10% higher, the Cash Creator will have to pay roughly an additional 10% of the NAV they paid when the creation happened. Nadig takes you through the rest of the math, which you can do on your own. In the end, it looks like this magical EGPT trade is probably not a screaming slam dunk, just a fair trade, as the ETF is still pricing in a sizable jump in the Egyptian positions.
Now, why didn’t I realize this before? Cash creations are pretty unusual in the ETF world. More importantly, the details above are not mentioned in the EGPT prospectus – only in the SAI (Statement of Additional Information), which itself is not linked from the Van Eck EGPT home page.
I have a mantra that I always keep in my mind: I am not smarter than the market. Any time I think that I’ve found a spot where I think that the market is clearly mispricing something, I try to approach it from all angles to figure out why the mispricing might exist. In the case of EGPT, I thought I had found exactly such a dramatic mispricing, resulting from a tiny retail product held by unsophisticated investors, and the lack of an arbitrage mechanism resulting from the lack of stock borrow. It turns out that the mispricing is probably not as dramatic as I’d thought.
Note, however, that I still think Van Eck should have disallowed this cash creation in the first place. The SAI states that they can refuse such creations under:
acts of God or public service or utility problems such as earthquakes, fires, floods, extreme weather conditions and power outages resulting in telephone, telecopy and computer failures; wars; civil or military disturbances, including acts of civil or military authority or governmental actions; terrorism; sabotage; epidemics; riots; labor disputes; market conditions or activities causing trading halts; systems failures involving computer or other information systems affecting the Trust, the Adviser, the Distributor, DTC, the NSCC or any other participant in the creation process, and similar extraordinary events.