[Editor's note: This story has been updated from an earlier version and now includes comments from the NYSE. See below.]
When an ETF starts to trade at a significant premium to its net asset value (NAV), it usually means the creation/redemption process, the mechanism by which ETF shares are made or destroyed, has fundamentally broken.
So has something broken within the ETFMG Alternative Harvest Fund (MJ)?
Earlier this week, MJ's issuer, ETF Managers Group (ETFMG), replaced the fund's former custodian and transfer agent—U.S. Bank and its parent company, U.S. Bancorp—with Wedbush Securities and Computershare, respectively (read: "Marijuana ETF Shifts Custody").
Over the past two days, since the change was announced, MJ has seen a sudden and substantial spike in its trading premiums. As of 2 p.m. ET on Sept. 20, the premium had risen to 3.2%:
Source: Bloomberg.com; data as of Sept. 20, 2018
Where did this significant trading premium originate—and is it connected, somehow, to MJ's new service providers?
Good Month For MJ
MJ isn't known for exhibiting historically large trading premiums or discounts: Over the past 12 months, the fund's median premium/discount was just 0.03%. Any trading premium or discount that arose was arbitraged out quickly by the fund's authorized participants (APs).
This has remained true even as the performance of the fund's underlying marijuana stocks has gone through the roof, and performance-chasing money has poured into MJ. Since Aug. 20, MJ has taken in $104 million in new net assets.
Yet through it all, MJ retained relatively small premiums and discounts—until two days ago, when it came to light that MJ had replaced its custodian and transfer agent.
What Is A Transfer Agent?
We've reported in the past on MJ's issues with its custodian (read: "Promise & Peril Of Marijuana ETFs"). However, this recent spike in trading premiums instead may be related to the ETF's new transfer agent, Computershare.
A transfer agent plays an often-overlooked but essential role in the creation/redemption process to generate or destroy ETF shares (read: "So You Want To Launch An ETF").
To create new ETF shares, APs present an ETF issuer with a basket of the underlying index's stocks. The ETF's distributor takes those shares and passes the order on to the transfer agent, who creates new ETF shares in big chunks known as creation units (read: "What Is The Creation/Redemption Mechanism?").
To destroy ETF shares, the reverse occurs: APs present some number of creation units' worth of ETF shares to the issuer, and the transfer agent redeems those shares into the constituent stocks.
The transfer agent also maintains records of all this creation and redemption activity, for the benefit of the issuer, investors and all parties in between.
NSCC Membership A Must
Given the transfer agent's role in creating and redeeming ETF shares, it is essential they have membership in the National Securities Clearing Corporation (NSCC), which provides the centralized clearing, settlement, risk management, central counterparty services and transaction completion for the vast majority of stock and ETF trades occurring in the U.S.
Through the NSCC, the transfer agent processes all creation and redemption orders for the ETF, which clears, settles and completes them much like any other stock or ETF trade.
The transfer agent is also usually responsible—from a plumbing prospective—for giving the NSCC information about what is in the basket needed to do new creations (called the “portfolio composition file” or PCF).
In MJ's prospectus, for example, ETFMG writes: "Each business day, portfolio holdings information will be provided to the Fund's transfer agent or other agent for dissemination through the facilities of the NSCC… in connection with the process of purchasing or redeeming Creation Units or trading shares of the Fund in the secondary market."
Intriguingly, Computershare—which has never before taken on the transfer agent role for a U.S.-listed ETF—is not a listed member of the NSCC, according to the September update to the NSCC's member directory.
While it is possible the firm has become a member in the intervening time since that update, it is unlikely, as NSCC membership applications can take up to three months to process and be approved, according to the NSCC's website.
Can Computershare Process Creation/Redemption Orders?
Therefore, a lack of NSCC membership would imply that Computershare does not have the ability to process creation or redemption orders for MJ—representing a significant breakdown in the creation/redemption process for the fund. Effectively, it means no new shares of MJ can currently be created or destroyed.
Without the ability to create and redeem new shares, significant trading premiums would develop in MJ if there is investor interest in buying up shares—which is exactly what we seem to be seeing.
Neither Computershare nor ETFMG immediately responded to requests for comment.
Creations For MJ Suspended?
The NYSE, which runs the NYSE Arca exchange upon which MJ is listed, would neither confirm nor deny that creations in the fund were halted. Nor is MJ listed on its website among the ETPs that have currently suspended the issuance of new shares.
If creations have been suspended, however, the exchange requires the issuer report that information to the exchange at least 10 minutes in advance of issuing a press release announcing the changes to the general public.
“When the creation/redemption process breaks down, ETFs stop being ETFs. They become de facto closed-end funds,” said ETF.com Managing Director Dave Nadig. “If that’s in fact what’s happening here, it’s bad for investors, and the lack of communication around it is frankly unprecedented.”
It’s possible that APs have, for some reason, simply chosen to allow MJ to trade at a historically significant premium, and that the underlying plumbing is fine. Regardless, investors should be extremely cautious trading any ETF that exhibits unexpected premiums, or discounts. That certainly applies here.
This is a developing story, one we will update as more information comes to light.
Update: 11 a.m. ET:
Earlier today, the NYSE confirmed that exchanges must be notified by the issuer if creations are suspended and that the NYSE would post that information on the public website. The exchange has not received any notice from the issuer to that effect.
Furthermore, it appears that at least one creation has taken place since Computershare became MJ's transfer agent. On Sept. 19, the number of shares outstanding rose from 15.65 to 16.6 million.
On one hand, that creation/redemptions continue to occur in MJ should be a breath of relief for investors.
On the other, one create in a week is a much slower pace of creations than we've seen over the past month, in which $104 million has flowed into the fund and creations/redemptions occurred on a daily basis:
Source: Bloomberg; data as of Sept. 21, 2018
The slowdown in creates seems to imply that few APs have yet been signed through Computershare's systems. Not unsurprising, given the sudden termination of ETFMG and U.S. Bancorp's relationship on Sept. 14 (read: "Marijuana ETF Shifts Custody").
If there is in fact a lack of APs for MJ, it is still not a good thing for investors. Until more are onboarded, it will mean that MJ's trading premium—which, as of publication time, was around 2.7%—is likely to persist.
Contact Lara Crigger at [email protected]