ETF Alert: Watch Out For Temporary Effective Creation Of Pseudo-Closed-End Funds

by: Peter F. Way, CFA


Eleven ETFs have new unit creation abilities terminated.

Same eleven have unit redemptions continued.

Creation terminations are required by regulatory conditions.

Conditions are temporary, ETFs are to return to former marketability assurances in next few days.

Bias in market prices possible in the interim, creating subsequent loss possibilities for purchasers in bias period.

What has occurred

ProShare Advisors LLC, the biggest U.S. provider of leveraged and inverse exchange-traded funds, suspended the creation of new shares in 11 funds pending unspecified changes to the products' registration statement.

"The temporary suspension is due to a regulatory filing requirement that we expect will be resolved in the next few business days," the Bethesda, Maryland-based company said today in a statement.

The suspension could result in "significant variation between the market price at which shares are traded and the shares' net asset value," the company said. ETFs create and redeem shares in transactions with market makers and other trading firms in response to demand, which keeps a fund's share price closely in line with the value of its underlying holdings.

Redemptions involving the funds aren't affected, according to ProShare, and the shares continue to trade. ETFs are bundles of securities whose shares trade like stocks on an exchange and usually track an equity, bond, commodity or currency index.

The affected ETFs hold $386 million in assets and include the $203 million ProShares Short VIX Short-Term Futures (SVXY) ETF, according to data compiled by Bloomberg. The funds use derivatives and seek to offer investors multiple or inverse returns on an underlying index, such as the VIX, which measures expected equity-market volatility.

What it means

ProShare Advisors took the lead in leveraged and inverse ETFs through the legal acuity of its founder, and the firm has maintained an awareness of things regulatory and public reaction to legal issues for the several years of its existence. The impression given knowledgeable observers is that the present situation is most likely one taken at the initiative of the firm, rather than under duress by regulators.

The constraint being imposed has to do with the creation of new ETF shares that are issued as public market demand dictates, by market professionals credentialed to do so. As a parallel to the scale of single-company shares trading, where there may be odd-lot, round-lot and block trades, in ETFs the creation units are most like block trades, done with the purpose of accommodating an increased demand from investors for greater capital capacity in specific ETF issues. The creation of the ETF shares requires the acquisition and sequestration of an appropriate scale of what the ETF has held at the time of the new creation. The new ETF shares are then made available to the public in odd lots or round lots, perhaps even in volume if such orders exist.

The ETF prices tend to reflect the fund's net asset value, as may be influenced by the new holdings acquisitions by the ETF in the process of unit creation. If public investment appetite for an ETF wanes, an opposite process of redemption and reduction in the holdings of the ETF may take place.

By temporarily suspending the creation of new units, the supply of ETF shares is constrained, and market price of the ETF might rise more than it would under similar demand conditions when creation of additional units is possible. Since the opposite side, of unit redemption, is not being constrained, the weakened demand for ETF shares will likely be faithfully reflected by the normal process.

So the situation is one that presents the possibility of an upward bias in ETF prices, without any likely artificial increase in downside risk. The potential for risk exists mainly in an investor who might become a buyer during the time that the ETF's price was biased upwards. Once the upward bias situation is eliminated by the renewal of unit creation, there is a possibility of loss that might not have occurred without the disruption of unit creations.

In the event of other ordinary developments creating market enthusiasm for such an ETF, that loss potential is heightened. But under normal circumstances, what is more likely is a reduction of demand volume in these ETFs until the situation returns to normal.

Here are the ETFs that are involved

ProShares Ultra DJ-UBS Commodity (NYSEARCA:UCD), ProShares UltraShort DJ-UBS Commodity (NYSEARCA:CMD), ProShares Ultra DJ-UBS Natural Gas (NYSEARCA:BOIL), ProShares UltraShort DJ-UBS Natural Gas (NYSEARCA:KOLD), ProShares Ultra Australian Dollar (NYSEARCA:GDAY), ProShares UltraShort Australian Dollar (NYSEARCA:CROC), ProShares Ultra Euro (NYSEARCA:ULE), ProShares Short Euro (NYSEARCA:EUFX), ProShares Ultra Yen (NYSEARCA:YCL), ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) and ProShares VIX Mid-Term Futures ETF (NYSEARCA:VIXM).

The Net Asset Values currently invested in these, along with their price leverage structures are as shown:

The ETFs that have sufficient market-maker activity to offer some price forecast ideas are as follows.

A quick explanation of the less-obvious numbered columns: (5) is the % change between (4) and (2). (12) tells, out of the total number of forecast days available, that sample number of those days with Range Indexes like the present. The Range Index (7) is the percentage of the forecast range (2 to 3) that lies below the forecast day market price (4). Using the prior sample in (12) to follow a standard, simple time-efficient holding discipline, (8) indicates the percentage of them that were profitable, (9) the average net gain on all such holdings, (10) tells how long on average the samples were held, and (11) the rate created by (9) and (10). (13) measures the credibility of (5) given (9), and (14) compares (5) to (6).

Please invest the time and effort it may take to understand the dose that is inflicted by all of those ( )s in the prior paragraph. The data does provide a useful way to compare some not-so-simple, but realistic, investment considerations.

For example, the critical starting point in each is the benefit being offered by each forecast in (5), largest for BOIL, smallest for CROC. Past experiences of (9) say SVXY's +10.0% is most credible of the group, and those of KOLD is the least believable.


Until these ETFs are returned to normal balances in their unit creation and redemption market disciplines, it is advisable to refrain from new buying activities in any of them. Sales, if desired, are likely to be relatively unaffected by the circumstances. Short position holdings (except for SVXY, a special circumstance) might be exposed to more than ordinary risk, of a temporary nature. SVXY, as an inverse structure in an underlier that moves in opposition to the price of the S&P500 is the equivalent of a double negative, or a positive, moving usually in sympathy with that index.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.