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Though ETFs may appear as very simple and straightforward investment vehicles, there is a rather complex infrastructure that lies beneath the surface. Under the hood of exchange-traded products is a unique “creation / redemption” mechanism that allows for the number of shares outstanding to fluctuate based on supply and demand. Generally, this mechanism serves a very useful and practical purpose: It keeps the prices of ETFs in line with the value of the underlying securities [see 25 Things Every Financial Advisor Should Know About ETFs].

When the value of an ETF climbs above its NAV, new shares can be created from the components and sold at an arbitrage profit (and vice versa). The efficiency of the creation / redemption mechanisms allows those transactions to be executed almost immediately, thereby creating a powerful incentive for opportunistic institutions to turn a profit by keeping ETF prices in line with their NAVs.

This mechanism is the reason why the price of most ETFs is generally very close to the aggregate value of the underlying securities. But, as is often the case, there are exceptions to this rule. For various reasons, some exchange-traded products can deviate from the value of the underlying securities–sometimes by a significant amount. Below are three ETPs currently trading at a significant premium to their underlying value:

iPath Dow Jones-UBS Natural Gas ETN (NYSEARCA:GAZ)

Premium: 116% above NAV (as of 3/8/2012)

Cause Of Disconnect: That isn’t a typo above; GAZ was recently trading at a premium to its NAV of more than 100%. That figure has slowly crept higher in recent months ever since creations of new shares were suspended due to concerns over a changing regulatory environment. When new shares of an ETN can’t be created, the creation / redemption mechanism breaks down and a premium can develop if demand for the shares remains strong. GAZ still has more than $35 million in assets, and trades some 200,000 shares per day.

Alternative ETF: There are a number of other exchange-traded products that offer exposure to natural gas futures, including the United States Natural Gas Fund (NYSEARCA:UNG) and Teucrium Natural Gas Fund (NYSEARCA:NAGS). Though there are some structural differences–UNG and NAGS will deliver a K-1–the exposure offered is substantially similar [see also 25 Ways To Invest In Natural Gas].

The huge premium in GAZ is a bit perplexing given the fact that alternative products also offering exposure to natural gas are trading very close to their NAV. The premium isn’t sustainable over the long haul; assuming the indicative value remains the same, investors will receive less than 50 cents on the dollar when GAZ matures. If you have a position in GAZ, now is a great time to sell high and redeploy capital to UNG or NAGS (in case you’re wondering, there are no shares of GAZ available to short).

VelocityShares 2x Short Term VIX Futures ETN (NASDAQ:TVIX)

Premium: 14% (as of 3/8/2012)

Cause Of Disconnect: This premium is a relatively recent development, as Credit Suisse suspended creations of TVIX in February due to “internal limits on the size of the ETNs”. TVIX, which offers 2x daily leveraged exposure to an index comprised of VIX futures contracts, has become a pretty popular tool. Currently, assets stand at more than $550 million. That means that the ETN holds a significant number of futures contracts, which could eventually cross regulatory limitations on the number of securities that can be held by a single product.

Alternative ETF: The ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) offers substantially similar exposure; that product also seeks to deliver daily returns equal to 200% of an index consisting of short term VIX futures. Again, there are some structural differences; TVIX is an ETN while UVXY is an ETF. But UVXY is trading right in line with its NAV, which could eliminate a source of uncertainty for investors looking to use the VIX as a hedging tool.

Market Vectors China A-Shares ETF (NYSEARCA:PEK)

Premium: 9% (as of 3/8/2012)

Cause Of Disconnect: Unlike GAZ and TVIX, the premium in PEK results from nuances related to the asset class covered. PEK is the only U.S.-listed ETF to offer access to China’s A-Shares market, a type of security that until recently was accessible only to investors in mainland China. Even now, there are significant restrictions on ownership of A-Shares; a relatively small number of permits to buy these securities has been issued. PEK obtains this exposure through total return swaps with a qualified investor, and significant demand for access to A-Shares securities results in a significant premium to NAV.

Since its inception, PEK has regularly traded at a premium, which has generally ranged from 2% to 10%. For the time being, if you want exposure to the A-Shares market there’s no way around paying a premium over NAV.

Alternative ETF: As mentioned above, PEK is currently the only ETF available to U.S. investors interested in accessing the A-Shares market in China. Those looking to gain access more generally to the Chinese economy have several options in the China Equities ETFdb Category.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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Source: 3 ETFs Trading At A Huge Premium To NAV (And 3 Alternatives)