The iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (NYSEArca: GAZ) has been trading at a premium of as much as 10 percent above net asset value this week, the result of a recent spike in demand coming after the ETN’s issuer halted creations of new notes in August 2009.
Halting creations of new GAZ notes has essentially transformed the fund into a closed-end product, according to industry sources who spoke to IndexUniverse.com on condition of anonymity. GAZ ended Wednesday’s session at $7.79 a share, 6 percent above NAV of $7.34, according to data compiled by IndexUniverse.com. Spikes in demand are normally met by issuers creating new notes, thus keeping the price in line with NAV.
The spike in demand recently could be related to retail investors buying without being aware that GAZ creations are halted, or by more sophisticated traders and institutional investors who are trying to profit from pushing GAZ’s price higher, ETF traders and market makers told IndexUniverse.com.
Barclays halted creations on GAZ in August 2009, citing “current market dynamics and ongoing regulatory review,” as we reported last year. One industry source said creations stopped not because of an ongoing regulatory review of position limits for ETNs and ETFs that use futures, but because hedging costs to run the portfolio had simply become too expensive. A Barclays official declined to comment.
The question of hedging costs goes to the heart of one of the important distinctions between an ETN and an ETF. An ETF in the same position as GAZ, such as the United States Natural Gas Fund (NYSEArca: UNG), would just pass on higher hedging costs to shareholders. Those costs would show up in investor returns as higher tracking error. In the case of an ETN, which commits by contract to provide a precise pattern of returns at the note expiration, the note holder would be spared such tracking error, and responsibility for hedging that promise-to-pay is entirely the responsibility of the issuing bank (Barclays, in the case of GAZ), whatever the cost.
“With ETNs, you have no way of passing along those hedging costs,” one exchange-traded product industry source said, adding that hedging futures positions on futures-based energy commodity funds did indeed rise last year.
Clearly, the size of the fund isn’t the issue: UNG had almost $2.49 billion in assets as of Tuesday’s close, compared with $117.6 million for GAZ.
In its announcement last year, Barclays said the “temporary suspension” could impact other iPath ETNs. Indeed, in October 2009, Barclays halted creations on its iPath Dow Jones-UBS Platinum Subindex Total Return ETN (NYSEArca: PGM). PGM, which has $78.2 million in assets, is now trading at a slight discount to NAV.
How To Close GAZ?
The source said it was likely that the rising costs of hedging GAZ, plus marketing and distribution expenses, had probably pushed GAZ close to the edge of solvency.
“The question really is: When will iPath close GAZ?” the source said.
But the rub is that the ETN in particular, which is essentially a bond that promises the holder the returns of a given index minus expenses, isn’t callable.
Barclays addressed the issue of callability of GAZ and 18 of its other commodity ETNs in a regulatory filing in June that amounted to a replication of most of its commodity ETN lineup. We wrote about Barclays’ plans in a story titled “New iPath Commodity ETNs Look Like Cannibals.”
The new callable copycat ETNs—The iPath Dow Jones-UBS Natural Gas Subindex Total Return Callable ETN (NYSEArca: GAZC) in the case of GAZ—will come with an expense ratio of 0.70 percent, a touch cheaper than the 0.75 percent on the existing ETNs, in what amounts to an enticement for investors to make the switch, the source said.
The Barclays official said it’s not yet clear when the new ETNs will go live.
GAZ has drifted in and out of normal ranges since creations were halted, and has been steadily above NAV since about mid-September.
ETF industry sources contacted for this story suggested that retail investors unaware of the premium issue surrounding GAZ may be seeking a tactical allocation in natural gas before the weather cools down, but are simply choosing the wrong product to express that intent. Another possibility is that institutional investors are squeezing short-sellers by trying to force them to pay a premium to NAV to get out of their positions.
“The people who bought into the note before they halted the creations are loving this,” said one market maker who requested anonymity. “The losers are the people who are unknowingly buying now that this thing is trading at a premium with creations halted.”
ETNs are debt obligations backed by the issuer—Barclays in the case of GAZ. Apart from the issues like the one GAZ now faces, ETNs typically deliver returns extremely close to that of the underlying index, minus expenses, making them different from ETFs, which typically have some level of tracking error.
In this case, however, the NAV of the ETN is no longer relevant. Without a functional way to arbitrage price differences, investors should be extremely cautious of closed-end funds in ETN clothing like GAZ.
Natural Gas ETN trading as much as 10% above NAV
Commodities are really frothing, even more than the equities markets. Natural Gas ETFs and ETNs are just another case as it's normally retail investors who trade them, not having access or enough capital to trade futures contracts, as discussed by this IndexUniverse report. The report is also quite interesting to get insights about ETNs and ETFs from the investment banking/market making side.