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Using EWJ to Access Japan: A Price Discovery Case Study

Apr. 07, 2011 6:58 PM ETEWJ
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Bonds, Dividend Investing, ETF investing

Seeking Alpha Analyst Since 2011

Noel Archard, CFA is a Managing Director and Head of Product for North America iShares. He currently heads the iShares product function in the US, which is responsible for product research and development, product management, the management of iShares in capital markets and product services and analytics. Noel joined iShares in 2006, then part of Barclays Global Investors (BGI), which merged with BlackRock in December 2009. Noel is an associate of BlackRock Investments, LLC. BlackRock, Inc. and its affiliates are not affiliated with Seeking Alpha. He spent over 10 years at The Vanguard Group, first working with their brokerage service unit and then moving into their Exchange Traded Funds group. Noel has a BS degree from Northwestern University and is a Chartered Financial Analyst charterholder (CFA). He is a member of the Financial Analysts of Philadelphia and the CFA Institute, and holds Series 7, 24, 63 and 65 securities licenses.
Taken from iSharesblog.com

Last week, Alphaville blogger Izabella Kaminska warned investors to “beware your Japan exposure”, stating that the iShares MSCI Japan fund (EWJ) is not a proxy for Japan (or at least, “not completely”). Kaminska noted the sizable premium to net asset value (NAV) that EWJ and other U.S.-listed Japan ETFs have experienced at market close the past couple of weeks, shrugging off the explanation provided by Index Universe that due to time differences “these price discrepancies are not premiums in the traditional sense, . . . but gauges by the U.S. market of the expected value of the underlying securities once they open the following day.” Since the concept of premium/discount in international ETFs tends to cause a lot of confusion, I hope I can shed some light on the subject. 
First, to address the premium issue. EWJ holds a basket of Japanese stocks that trade on the Tokyo Stock Exchange during its market hours of 9am to 3pm (8pm to 2am ET).  When EWJ opens for trading on the U.S. market the next morning, it can serve as a price discovery vehicle, allowing investors to continue to gain access to the closed securities and help determine a current price based on the most recent news and information. EWJ’s end-of-day NAV is then calculated based on the underlying securities’ closing prices from 14 hours earlier. This means that the closing price (based on current investor sentiment) and the NAV (based on local markets long closed) will almost always differ–a discrepancy that can become more pronounced when there are market-disrupting events in play.  
You can see how NAV and closing market price are rarely, if ever, going to be the same–but there’s no telling if the difference will be a premium or a discount. This is why the assertion that authorized participants used the time difference to their advantage, “buy(ing) Japanese stocks cheaply (while U.S. markets were closed) for the purpose of creating baskets later to sell to U.S. investors at a premium,” is a bogus one. It’s essentially like saying that a market maker in the U.S. on Tuesday has precise knowledge of where Japan will be trading on Wednesday–never mind all the unknowns that exist in that scenario.   
Check out the graph below, which maps the percent change in price of EWJ, the U.K.-listed iShares Japan ETF (which also tracks the MSCI Japan Index), and the MSCI Japan Index the week following the earthquake and subsequent tsunami in Japan.  After the index traded down in Japan on Monday March 14th, the U.K ETF opened just north of Japanese markets and later traded almost in lockstep with EWJ during U.S. market hours. News of the escalating nuclear crisis caused further decline during Japan’s Tuesday session before investor sentiment again buoyed the ETFs during the U.K and U.S. trading days. Note that 1.5 hours pass between Japan’s close and the U.K.’s open, and 4 hours pass between the U.S.’s close and Japan’s open–and news is being disseminated around the clock.
 Please click here for standardized performance for EWJ.
Source: Bloomberg 3/13/11 – 3/16/11. Past performance does not guarantee future results. 
We can speculate about what caused investor sentiment to change direction, but what’s more important is that the market price of the U.K. ETF and EWJ reflected the aggregate view of the underlying basket of securities as determined by the supply and demand seen on the exchange. Each of these ETFs provided an actionable price that incorporated all the current information and risk that the market perceived about the underlying equities, given the fact that these securities were currently unavailable to trade. What’s more, EWJ’s volume spiked significantly during this time period, reaching almost $4B on 3/15 (over 12 times its already substantial average daily volume (ADV) in the month of February). And spreads remained at a penny. 
Is EWJ a perfect proxy for Japan? I’d go out on a limb and say it’s one of the closest proxies available for U.S. investors. It gives U.S. investors the opportunity to invest in a diversified basket of Japanese securities during U.S. market hours, and it gives the investment world a vehicle to price new information into the securities even when they are closed for trading on their local exchange - that’s about as close as you can get. At the end of the day, EWJ worked exactly how we’d expect it to work in a tumultuous market, and that’s what counts in our book. 
Source: Bloomberg 
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