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An interesting situation has developed with the Morgan Stanley China Fund (NYSE:CAF). Normally only Chinese citizens can purchase China A-shares. But some A shares have been alloted to "Qualified Foreign Institutional Investors" or QFII's. Morgan Stanley is a QFII and used a portion of their QFII allocation to form the (CAF) closed end fund which trades on the NYSE.

The net asset value of CAF has performed brilliantly this year and has appreciated 71.2% year to date. But the CAF market price has lagged way behind and is only up 15.8%. On 12/31/06, CAF was selling at a premium over NAV of +16.06% and it now trades at a discount to NAV of minus 21.47%.

One reason for this discount developing is that CAF is one of the few ways for institutional investors to sell short the China A shares in the US market. Some institutional investors are QFII-qualified and are long China A shares and are selling short CAF to hedge their exposure. The selling pressure has caused the widening in the discount.

There are several other China closed end funds that sell at somewhat smaller discounts, such as the Greater China Fund (NYSE:GCH), JF China Region Fund (NYSE:JFC), the China Fund, Inc. (NYSE:CHN), Templeton Dragon Fund (NYSE:TDF). But these funds invest mainly in stocks trading on Asian exchanges outside of China. CHN also looks attractive, since its expense ratio is only 1.26% which is about 70 basis points less than CAF's.

Alan Greenspan recently called the "bubble" in the China stock market which caused a correction in the China funds on Thursday. But CAF bounced back and recovered the loss on Friday. Greenspan has a pretty poor record as a stock market prognosticator. He "called" a top in the Nasdaq in 1996 which was way too early. Of course the Chinese market will eventually have a big drop, but this may not occur until after the Chinese Olympics. Greenspan has built a career on predicting the obvious or the consensus opinion, and if anything should be used as a contrarian indicator.

For the risk averse who wish to bet on the discount narrowing in CAF, a good way to partially hedge is to sell short iShares FTSE (NYSEARCA:FXI). FXI is an ETF that sells close to NAV. It also invests almost 100% in China shares. It is not a perfect hedge for CAF, since the sector investments in FXI are quite different from CAF.

CAF vs. FXI 8 month chart:

Source: Morgan Stanley China Closed End Fund: NAV Up While Market Price Lags