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The efficient-market hypothesis (EMH) requires that investors have “rational expectations,” that on average the population is correct and whenever new information appears, expectations are updated appropriately.
Nice theory, but in the real world investors are anything but “rational.” As human beings, we tend to overreact to new information, behaving in an irrationally exuberant or irrationally despondent fashion.
The latest example of this irrational behavior has been on full display over the past week. Even before President Obama’s announcement of policy changes toward Cuba, investors were scrambling for ways to “play it” (as a side note, I doubt most of these “investors” could quantify how much the policy changes would actually benefit the companies they were buying, but that is a topic for another day).
Their vehicle of choice quickly became the Herzfeld Caribbean Basin Fund, a closed-end fund with the ticker “CUBA.” Over the past week the fund has more than doubled in a vertical move higher accompanied by a substantial increase in volume.
Now here’s where it gets interesting.
While the ticker is “CUBA,” there are no actual Cuban companies in the fund’s holdings, only companies that might benefit from a shift in policy towards Cuba. All of the holdings are easily accessible through U.S. shares or ADRs and are traded on the U.S. exchanges.
But it is certainly easier for investors to buy one ticker rather than going through the trouble of replicating the holdings of CUBA. This must be the reason for the huge increased demand for the fund.
Perhaps, but what if I told you that you needed to pay a 70% premium for this easy access. You would probably have a few choice words for me, but that is exactly what investors are doing today as the fund’s share price of $14.12 is over 70% higher than the value of its underlying securities at $8.27.
In an act that can only be described as irrational exuberance, investors have bid up shares in this fund to well beyond the value of its underlying holdings. We can see this visually by looking at a few of the fund’s top holdings.
Copa Holdings (CPA), 8.5% position:
Mastec, Inc., 6.3% position:
Coca-Cola Femsa SAB, 6.0% position:
While these shares have advanced over the past week, they have not come close to supporting the gains in the CUBA fund. In an efficient market, such a wide divergence would never happen, as arbitrageurs would step in and short the fund while buying the underlying holdings to earn a “riskless” profit. In an efficient market, no investor would choose to buy CUBA at a 70% premium when they could buy the underlying holdings at no premium at all.
But the markets are far from efficient and a key reason for that is that investors are far from rational. The CUBA fund is merely the latest example. It has happened before and it will happen again as long as human behavior is a driving force in markets.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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