EGPT: Looming Tracking Error

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By now, we've all seen the news. The Egyptian stock market is closed. In response, Van Eck has halted creations on the Market Vectors Egypt ETF (NYSEArca:EGPT), the only ETF in the world focused solely on the Egyptian market. That means that Van Eck will no longer accept orders to create additional shares of the fund.

In general, we applaud these kinds of actions. EGPT, unlike most ETFs, processes most of its creations and redemptions in cash. When an authorized participant wants to create additional shares of the fund, they send cash to Van Eck. Van Eck then goes into the market and puts that cash to work. With Egypt's stock market closed, Van Eck can't put that money to work effectively; therefore, it's no longer creating more shares of the ETF.

That hasn't stopped the fund from trading, however. EGPT traded more than 800,000 shares yesterday. More interestingly, it traded up sharply, rising 7.86 percent on the day.


That last bit is interesting because competing funds with significant exposure to Egyptian stocks traded absolutely flat yesterday. The Market Vectors Africa ETF (NYSEArca:AFK), for instance-which has a 21 percent weight in Egyptian shares-closed the day up just 0.03 percent. The PowerShares MENA fund (NYSEArca:PMNA) traded down 0.31 percent on the day.

Why the run?

Well, you could argue that the parts of AFK not invested in Egypt fell enough to offset the sharp rise in Egyptian shares reflected in EGPT. That doesn't seem to be the case. AFK's single largest country exposure is South Africa, at 30 percent of the fund. The largest South Africa ETF (NYSEArca:EZA) traded up 1.22 percent yesterday.

AFK_vs_EGPT_PMNA_Px

Alternatively, you could suppose that EGPT has been artificially bid up in price. With the creation window closed, there are a fixed number of shares of EGPT. If too much demand is chasing those shares, they may drive the price up. In effect, EGPT is a closed-end fund, and investor demand will drive prices up, regardless of fair value.

To be fair, there is no way to say what the "fair" value of EGPT is; we won't know that until the Egyptian market reopens. A handful of large positions in EGPT are actually tradable right now:Orascom Construction and Telecom, the two largest positions in the fund, trade in London, as does the fund's No. 3 holding, Centamin. TransGlobe Energy (No. 5) trades in Canada. Several of those positions seem to be on fire here, suggesting that EGPT is actually acting as the price discovery mechanism, not just a balloon.

EGPT_vs_Oras_Telcom_TRR

There are two other interesting wrinkles here.

First, we now know that Van Eck fielded significant creation orders last Friday, with about $12 million in cash pouring into what was then an $11 million fund. There is no way that Van Eck was able to put this money to work in local shares, as the local market was closed at the time. Indeed, looking at the holdings going into this morning showed a massive 40 percent cash position. Van Eck simply can't get that money to work fast enough.

What will the company do? Probably the only thing they can do is pile that money into those securities in the index that trade depository receipts in either London or Canada. That now covers about a fifth of the fund.

Most likely, if the Egyptian stock market stays closed for a number of days, we'd expect to see a massive overweight in the ADR-able securities show up in EGPT's holdings. That may cause tracking error against the index whenever that market opens again; still, it's the only thing Van Eck can do. It's unlikely they sit on cash.

Interestingly-and smartly-Van Eck has left open the redemption window, meaning authorized participants can return blocks of shares to Van Eck and demand cash payouts. With the fund unable to sell securities on the local market to raise cash, what will happen here?

If it happens today, it's easy-they unload some of the unwanted cash. If they've already put the money to work, they will sell the ADR securities in the portfolio, taking on added tracking risk but maintaining the redemption capabilities. If it runs out of ADR assets, it has the right to reject redemption requests; more likely, it would close the redemption window before that ever happens.

The important note for investors is that Van Eck is not doing anything wrong here, and EGPT is working just as designed. The fund is now a flawed representation of the index it aims to track, but it is the best you can do. If you want to trade Egypt, it's EGPT or nothing.

We don't really know what the true premium in EGPT is. As happened with the junk bond market in fall of 2008, the ETF has really become the price discovery mechanism. We'd argue that EGPT is the best measure of what will happen when EGPT opens, and the best auction on sentiment in the world right now.

But a giant caveat remains:When the markets do reopen, it's unquestionable that that auction will have been wrong-to the upside or to the downside. Our bet is that EGPT is inflated over that future price, so we'd suggest treading with caution.

Ticker

Fund

% Weight in Egypt

Volume on 1/31/2011

TRR 1/25 to 1/31/2011

TRR 1/25 to 2/1/2011

PMNA

PowerShares MENA Frontier Countries Portfolio

17.93

38,229.00

-6.99

-6.13

GAF

SPDR S&P Emerging Middle East & Africa

21.12

203,699.00

-4.33

-2.47

GULF

WisdomTree Middle East Dividend

11.03

60,233.00

-2.10

-4.71

EGPT

Market Vectors Egypt

86.69

819,136.00

-6.64

-4.93

FRN

Guggenheim Frontier Markets

10.77

937,506.00

-3.66

-1.05

AFK

Market Vectors Africa Index

25.36

96,393.00

-7.29

-5.97

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: AFK , EGPT , EZA , PMNA

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