After a stunning 60% decline in a VIX ETN (TVIX) sponsored by Credit Suisse, another ETN has taken a nosedive. This time it’s the iPath DJ-UBS Natural Gas ETN (GAZ), which has declined more than 55% in value since its March 19 closing price of $6.02.
This latest episode is casting new doubts about the reliability of ETNs in obtaining market accurate exposure to stocks, bonds and commodities. GAZ was designed to closely follow natural-gas futures contracts, but it has been way off course.
Although GAZ, a Barclays product, now trades at a 63% premium to its underlying assets, it once traded at 134% premium to the value of its natural gas benchmark.
What’s going on?
In August 2009, Barclays stopped issuing new GAZ shares, which the company acknowledged could cause the ETN to trade at a premium or discount in relation to the note’s indicative value. As a result, GAZ shares began to trade higher in value, far above their indicative value.
These distortions in an ETN’s share price from the value of its underlying assets is a serious product flaw that has long plagued closed-end mutual funds. These flaws are compounded for ETNs that use 2x and 3x daily leverage.
Premiums and discounts can also occur with ETFs, but are typically smaller and less frequent, especially for heavily traded ETFs and funds that avoid futures contracts to get the bulk of their market exposure.
Some ETN providers will stop issuing new shares in a note to avoid exceeding futures contracts limits. But with just $36 million in assets, it doesn’t appear GAZ positions in natural gas futures were ever large enough to cause such concerns.
The Securities and Exchange Commission (SEC) is now examining trading in the Velocity Shares 2x Long VIX Short-Term Futures ETN (TVIX).
Like its GAZ counterpart, the Credit Suisse note has experienced significant operational problems. It’s unclear whether the SEC will expand its scrutiny of the broader ETN market. Currently, there are 211 U.S. listed ETNs with around $17 billion in assets.
What should advisors and investors do?
In a December 2011 article titled, “How to Avoid the Coming ETN Meltdown,” AdvisorOne readers were warned about the dangers of investing in ETNs.
The December 2011 edition of the ETF Profit Strategy Newsletter (published at ETFguide.com), looked at which ETNs could blow up first and provided a list of the top 15 ETNs by assets and 15 alternatives; it included three months of advanced warning, which shows that fiercely independent research and going against the Wall Street consensus is a winning formula.
While ETN investors wait for the smoke to clear, a defensive and proactive approach is required. If you are investing or trading in ETNs that carry substantial premiums or discounts, be forewarned: You are not making a directional trade based upon the ETN's underlying benchmark or index, but rather an arbitrage trade. And if you’re anything but an institutional investor with the toolkit to make arbitrage trades, you’re swimming with sharks.