Any exchange-traded fund (“ETF”) or exchange-traded note (“ETN”) without a fully functional creation and redemption mechanism is a broken product.
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.
Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.