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

An interesting situation has developed with the Morgan Stanley China Fund (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 (GCH), JF China Region Fund (JFC), the China Fund, Inc. (CHN), Templeton Dragon Fund (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 (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:

Comments

[iddjjs:]

The more discount, the safer to buy CAF. At some point, something will happen to correct the situation. I see two things could happen - 1. someone who has the market maker capability will come out and buy CAF in the open market and redeme for underneath China A-share, and then sell them in A-share market for huge profits. Their buying would effectively reduce the discount. Citigroup did so in IFXAF, sold over 25% of total IFXAF shares and effectively reduced the discount gap from 16% down to 8%. Another thing could happen is that Morgan Stanley could decide to change the close-end fund to open-end fund, thus to eliminate the discount all together. In any event, these shorts will have to cover sooner or later. So the bigger the discount the safer to buy to buy now.

Last Sat. I predicted that Shanghai composite would go up this week and finish above 4300 by the weekend, and finish above 4500 by the end of June. Apparently I was too conservative again - SSE took only two trading days to finish at 4335 last night, up 4% from last Friday's closing of 4170. Is it possible that 4500 will be taken down by the end of this week? Well, at this point I don't see any force existing that can stop this. If it does happen, then 5000 would be the milestone to June! Will the gain translate to CAF? Hopefully! At 4500, CAF's NAV will be roughly $50. If CAF still stuck at $36, then the discount will be roughly 30%! Sounds like a bargain for Fidelity and the likes to chip in!!!

2007 May 29 04:16 PM

[Chimin Sang:]

ETS is as efficient as the people who run them. My guess is that CAF administrators do not want to close the GAP because there is no mechanism for them to go short. If they choose to close the gap, the only choice is to liquidate all their positions and go out of business.

2007 May 29 06:20 PM