Why a Lucrative TSMC Arbitrage Trade Is Too Dangerous for Hedge Funds

The long-favored arbitrage strategy of buying Taiwan Semiconductor Manufacturing Co.'s (TSMC) Taipei shares while shorting its US-listed American Depositary Receipts (ADRs) has become increasingly challenging and risky for hedge funds. Despite the potential profitability, the widening gap between the Taipei and US stock performances has raised concerns among traders, prompting a reassessment of traditional trading tactics.



TSMC's ADRs have surged 66% this year through Friday, compared with a 55% advance in Taipei shares. However, the ADRs have traded at a premium of around 21% versus the Taiwan stock, compared with less than 8% for the five-year average. This premium reached a high of 30% during the Lunar New Year in February, when the Taiwanese stock market was closed.

"A lot of people have set it up and are hoping that it collapses back to its longer-term, fair-value level," said Jon Withaar, head of Asia special situations at Pictet Asset Management. But the premium could still go higher, "and then there’ll be a lot of pain," he added.

The enthusiasm over artificial intelligence (AI) in the US has pushed TSMC's ADRs to their most expensive price versus the Taiwan stock since 2009 this quarter, data compiled by Bloomberg show. As of Friday, they traded at a premium of around 21%, compared with less than 8% for the five-year average. It reached a high of 30% during the Lunar New Year in February, when the Taiwanese stock market was closed.



TSMC's cutting-edge technology and reasonable valuation have made it a favorite play among global investors in AI. The ADRs have outperformed because they’re more easily accessible to foreign investors. They’re also included in gauges like the Philadelphia Stock Exchange Semiconductor Index and in exchange-traded products such as the VanEck Semiconductor ETF and iShares Semiconductor ETF, meaning that funds tracking them must buy the US-listed securities.

However, the increasing premium of TSMC ADRs over local shares has made the arbitrage strategy riskier for hedge funds. The strategy involves shorting the ADRs, buying the shares in Taiwan, and waiting hopefully for prices to converge. This strategy can be costly and risky, as convergence may not happen quickly, or the mispricing could worsen, leading to significant losses.

Moreover, geopolitical risks, such as U.S.-China tensions and Taiwan's status, can further impact the arbitrage strategy. Any disruption to TSMC's production facilities in Taiwan could have global implications, affecting the company's stock price and the arbitrage strategy's viability.

In conclusion, while the arbitrage strategy of buying TSMC's Taipei shares while shorting its US-listed ADRs may seem lucrative, the increasing premium, geopolitical risks, and the potential for significant losses make it too dangerous for hedge funds to pursue. Traders should reassess their tactics and consider alternative strategies to capitalize on the semiconductor industry's growth.