Unlike mutual funds, ETFs are bought not from the company that creates and manages the products, but from other market participants. While that arrangement is responsible for many of the benefits of ETFs - such as intraday liquidity - it also introduces some potential pitfalls. Specifically, using market orders can be potentially hazardous as it introduces the possibility of paying more for a security than it is actually worth. Whereas mutual funds are bought and sold at NAV, ETFs change hands at whatever price clears the market.
Fortunately, under every exchange-traded product is a mechanism that is designed to keep prices of these products closely aligned with the net asset value (NAV) of their underlying components. Authorized participants have the ability to create and redeem shares, allowing them to capture an arbitrage profit if a disconnect between price and NAV arises. If an ETP trades for more than its NAV, an AP will buy the underlying securities and exchange them for new shares, capturing the premium to NAV in the process. If an ETP trades at a discount, the AP will exchange shares of the ETF for the underlying securities.
The result is that the price of an ETP will seldom deviate materially from its NAV, as such a disconnect is quickly arbitraged away by one of the many Authorized Participants. But there are, of course, exceptions. The Egypt ETF (EGPT) recently traded at a premium to its NAV for more than a month, as the closing of the Egyptian Stock Exchange prohibited the issuer from issuing new shares. The Teucrium Corn Fund (CORN) occasionally trades at a big premium or discount when big swings in corn prices halt trading of the underlying securities.
GAZ: ETN Gone Haywire
In each of the aforementioned scenarios, the ETF is acting as a price discovery mechanism - allowing investors to express their opinion on an asset class when trading in the underlying securities has been halted for some reason, whether it be a government coup or corn futures hitting their daily limit. What is happening currently with the iPath Dow Jones-UBS Natural Gas ETN (GAZ) is another case entirely, and one that defies simple explanation.
GAZ is an ETN, a debt instrument linked to the performance of an index comprised of near-month NYMEX natural gas futures contracts. Recently, GAZ exhibited a considerable premium to its NAV, with shares of the ETN trading about 15% higher than the indicative value.
The premium in GAZ makes sense, but remains perplexing at the same time. The creation/redemption mechanism that typically prevents big premiums or discounts has been disabled for GAZ. That is the result of a decision made by iPath in August 2009 to suspend further issuances of GAZ. At that time, regulators were looking more closely into the impact of exchange-traded products on futures markets, and considering stricter position limits. GAZ wasn’t close to hitting those limits at the time, but iPath was proactive in avoiding any further regulatory scrutiny by simply suspending the issuance of new shares.
When interest in a product that is not able to issue new shares rises, existing shares will generally trade at a premium. Demand pushes up prices, and without the ability to create additional shares, the arbitrage opportunity does not exist (at least not explicitly). In other words, these products essentially trade as closed-end funds.
GAZ vs. UNG
The spike in the premium is bizarre, however, because investors have other ETP options for exposure to natural gas. And these other options are allowing new creations, and thereby permitting the arbitrage mechanism to function properly. The United States Natural Gas Fund (UNG), which has about $2 billion in AUM (making it close to 20x larger than GAZ), has continued to trade at a price close to its NAV. UNG actually closed on Wednesday at a discount of 0.18%.
The Teucrium Natural Gas Fund (NAGS), which spreads exposure to natural gas futures across multiple maturities, is also functioning efficiently. NAGS has consistently traded within a few basis points of its NAV, even though volume is considerably lower than both UNG and GAZ.
UNG and GAZ have historically exhibited a very strong positive correlation, essentially moving in lock step. But that relationship broke down last month as the mysterious GAZ premium materialized:
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Not surprisingly, the disconnect between these two funds was accompanied by a surge in trading volume for the ETN:
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So why would investors flock toward GAZ and its 16% premium when UNG offers an opportunity to gain exposure to natural gas without introducing the additional risks associated with any product effectively functioning as a closed-end fund? Unfortunately, there’s no easy answer for that question. The ETP structure makes it difficult even for the issuers to tell who is using the products, so the identity of those keeping the premium in GAZ inflated is impossible to discern. It may be sophisticated investors betting on movements in the premium. It would have seemed crazy to buy into GAZ at a 10% premium to NAV, but anyone who did has turned a nice profit.
Similarly, if the premium goes to 30%, anyone invested in GAZ would experience some nice gains not related to movements in natural gas prices. But the more significant risk seems to exist on the downside. Given the alternatives for exposure to natural gas, it seems unlikely that the premium can remain for the long term. A similar story played out in late 2009 when CFTC rules temporarily halted creations of UNG. The fund’s premium swelled to 20%, before ultimately collapsing.
Beware the Risks
Given the bizarre premium in GAZ, it’s important to understand the risks associated with the fund. The performance of this ETN depends not only on the price of natural gas, but on changes in the premium to NAV. And it’s very possible that the latter will be the primary price driver in the weeks ahead. If you’re lucky enough to have bought into GAZ before the premium appeared, now may be a great time to cash out. The windfall profits from this odd phenomenon aren’t likely to stick around forever, and the deflation of a premium results in the same loss of value that a more fundamentally-driven dip delivers.
If you’re looking to bet on natural gas, steer clear of GAZ. The premium will eventually collapse, meaning that a bet on this ETN could deliver poor results even if gas prices jump. UNG and the recently-launched NAGS are much better options for pure play exposure to natural gas, particularly in the current environment.
Disclosure: No positions at time of writing.
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