12/31/14   Broken Products

Editor’s Corner

Ron Rowland

ETF and ETN investors should avoid broken products.  I have repeated this caution numerous times over the years.  Upon hearing this warning, most investors want to know what a broken product is.  Once they understand the definition, they quickly grasp the danger.

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 combined allow market makers to keep the trading price very close to the value (often called the Intraday Value or the iNAV).

This is the “promise” behind ETFs and ETNs, and investors expect these products to live up to it.  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.  The typical retail investor does not have an easy way of knowing if a product is broken or not, and that is where the danger lies.  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 happening today.  You are probably aware that crude oil prices have been falling for a number of months.  More recently, natural gas prices plunged.  ETFs and ETNs tracking natural gas fell right along with the underlying commodity.  Last week, the United States Natural Gas Fund (UNG) dropped 12.5%.  The leveraged ProShares Ultra Bloomberg Natural Gas ETF (BOIL) was whacked for a 22.6% loss.  However, iPath Bloomberg Natural Gas ETN (GAZ), an unleveraged product tracking the same index as BOIL, gained 5.9%.

The reason for this is because GAZ is a broken product.  On August 21, 2009, Barclays “temporarily suspended” the creation unit process for GAZ.  More than five years later it is still suspended, straining the credibility of the word temporarily.  I’m willing to bet most investors are unaware GAZ is broken.

Without the ability to create and redeem units of GAZ, it is impossible for market makers to keep the trading price near the net asset value (“NAV”).  The NAV of GAZ went from $1.9182 to $1.5874 per unit last week, a plunge of 17.2%.  The price went the other way, increasing from $2.02 to $2.14.  GAZ started the week trading at a 5.3% premium and closed with a 34.8% premium.  The premium narrowed slightly the past couple of days, but it is now back up to 33%.  Anyone buying GAZ today is paying 33% more than it is worth.

This is not a traditional liquidity problem, as GAZ has averaged more than 100,000 shares a day over the past seven trading days.  This high volume suggests that many participants are unaware of its broken product status.  One day, regulators may require investors be informed they are buying a broken product by requiring a ticker symbol suffix or some other means.  Until then, be careful out there, and don’t get caught owning a broken product when the premium disappears.

We wish you a happy and prosperous 2015.

Investor Heat Map: 12/31/14


Utilities popped again this past week, climbing from second to first to end the year as our #1 ranked sector.  Utilities was the best performing sector for calendar year 2014, leading us to believe much of the recent upside action is “window dressing” from managers trying to make their year-end holdings look good.  Real Estate held the top spot for two weeks but slid down to second today.  Consumer Discretionary jumped four spots to third, pushing Consumer Staples down to fourth in the process.  Financials held steady in fifth while Technology slipped to sixth.  Despite being the second best performing sector for the week and the entire year, Health Care lost a little momentum and slipped to seventh.  Industrials remains in eighth and rounds out the sectors that are performing well.  The three laggards are Materials, Telecom, and Energy.  Energy is the only sector still posting negative momentum and remains in a steep downtrend.


Micro Cap climbed a spot to capture top honors.  The relative strength ranking of the eleven style categories now falls in an inverse-capitalization alignment.  Small cap stocks often outperform their larger brethren at the end of the year and into January, and that seems to be the case this year.  Micro Cap is followed by the three Small Cap categories, then the three Mid Caps, the Large Caps, and Mega Cap on the bottom.  There is no consensus regarding Value versus Growth.  Growth has the upper hand for Small Caps, while Value has a slight edge in the Mid and Large Caps.  Adding to the neutrality argument of Value and Growth is the fact that the Blend categories are stronger than both Growth and Value for the Mid and Large Caps.


The top six global categories remain in the same order as last week, and they have experienced little change in their momentum readings.  China is on top for the fourth week.  The established China benchmark ETFs do not include the China A-shares, which have gotten a huge boost recently due to being cross-listed in Hong Kong.  The U.S. market continues to rebound from its early December slump and is firmly in second place.  Momentum drops significantly after the U.S., although World Equity still has green pixels, which is a claim the remaining eight categories cannot make.  Japan lost ground this past week but was able to keep its fourth-place ranking.  Europe and EAFE weakened slightly, and Canada swapped places with the U.K. to join Europe and EAFE in the middle of the pack.  Pacific ex-Japan and Emerging Markets swapped places after both had positive weeks.  Latin America remains in a steep negative trend and has been on the bottom of the rankings for ten weeks.


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.


“The market keeps coming under pressure without the seasonal demand support. Right now we have more to go in this selloff; that is what the record amount of [natural] gas is doing to the U.S.”

MGene McGillian, Senior Analyst at Tradition Energy, 12/31/14


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