Broken Products

Any exchange-traded fund (“ETF”) or exchange-traded note (“ETN”) without a fully functional creation and redemption mechanism is a broken product. broken-products

ETFs and ETNs are unique securities. The primary feature that differentiates them from other investment vehicles is the ability to create and redeem shares, typically through an in-kind exchange process. Another key feature is the publishing of the underlying portfolio’s value throughout the trading day. The two features combine to create the soul of an ETF. They allow market makers to keep the actual trading price (market price) very close to the net asset value (often called the intraday value, intraday indicative value, or the iNAV) throughout the trading day.

This is the “promise” behind ETFs and ETNs, and investors expect these products to live up to this promise. However, sometimes the share creation mechanism is suspended or terminated for a given product, and that is when it becomes a broken product. Without a viable share creation process, an ETF or ETN can trade like a closed-end fund with price premiums or possibly discounts. The typical retail investor does not have an easy way of knowing if a product is broken or not, and that creates even more danger. It could be trading at a substantial premium, a premium that could disappear instantly.

This is not just a theoretical problem—it is very real and it happens on a regular basis. Deutsche Bank (DB) announced a temporary suspension on creations for its 26 ETNs back in March 2013. Three and a half years later, that “temporary” suspension is still in effect. A year ago, UBS trashed its lineup of ETRACS ETNs by suspending creations for all 38 of its Series A ETNs. Today, there are 65 ETFs and ETNs listed for trading on U.S. markets that are broken products. At the end of October, these products held $10.9 billion in assets.

Without the ability to create and redeem shares, it is impossible for market makers to keep the trading price near the net asset value. At that point, they become the equivalent of closed-end funds, but with one major difference. With closed-end funds, most investors know what they are getting into. They know that the closed-end nature of these products can lead to substantial premiums and discounts. With ETFs and ETNs, premiums and discounts are not expected, and there is no easy way for retail investors to be made aware of this.

In December 2014, the iPath Bloomberg Natural Gas ETN (GAZ) zoomed from a 5% premium to a 35% premium in less than a week. These premiums can disappear just as fast, leaving unsuspecting shareholders in the lurch. The most extreme example ever belongs to the Elements MLCX Gold ETN (GOE), which traded at 1,000% premium above its net asset value. These types of problems are not limited to ETNs, as it can happen to ETFs also, such as when the VanEck Vectors Egypt ETF (EGPT) traded at 30% premium to the value of its equity holdings.

For these reasons, ETF and ETN investors should avoid broken products. Professional arbitrageurs have armed themselves for these conflicts, and they are waiting to take advantage of unsuspecting market participants.

The sector rankings show little change from last week, and they appear to be settling in to their new post-election lineup. Telecom transitioned from negative to positive momentum, putting seven sectors into positive trends and four still moving in the other direction. The top six positions are identical to a week ago, although all are posting improved momentum readings today. Telecom climbed a notch to seventh and pushed Health Care a step lower. Utilities and Consumer Staples swapped places, with Utilities having a fractional advantage between these nearly tied sectors. Real Estate is on the bottom for a third week. It is interesting to note that a little over two months ago, major classification systems classified Financials and Real Estate within the same sector. For the past three weeks, these two have been on opposite ends of our rankings, and today there is a whopping 94-point spread between them. They are clearly two different animals.

Last week’s upheaval in the factor rankings has stabilized this week, with only minor shifts in relative strength. All 11 categories are reporting improved momentum and two, Growth and Yield, transitioned from red to green. High Beta remains in the driver’s seat, which is expected when the market is in strong rally mode. However, what was surprising was the fact that High Beta held onto the top spot throughout the market pullback of October and early November—a sign of true leadership. Size has firmly nailed down the #2 spot, and Value is in third. Quality moved ahead of Dividend Growth, while Momentum and Low Volatility continue to lag.

The U.S. owns the top global ranking for a second week, and Canada jumped into the second-place spot to put North America in the leadership role. Canada flipped from red to green in the process and pushed Japan and World Equity each a spot lower. Seven global categories continue to report negative momentum, although there were a few shifts this week. China climbed three spots and the Eurozone fell three. China’s ascent broke up the trio of developing market categories that were at the bottom last week, and the Eurozone now finds itself wedged among the basement dwellers.



The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

“Investors are cautioned that paying a premium purchase price over the indicative value of the ETNs could lead to significant losses. An investor that pays a premium for the ETNs, for example, may suffer significant losses if the investor is unable to sell the ETNs in the secondary market, if the investor sells at a time when the premium has declined or is no longer present or if Credit Suisse AG accelerates the ETNs at its option.”

—Credit Suisse press release of 11/16/2016 announcing the creation suspension of two ETNs

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