When Arbitrage Fails
When the creation/redemption process is strained or broken, the ability to execute a trade close to the portfolio’s true value becomes compromised, and real premiums or discounts can appear. This happened a decade ago in the United States Natural Gas Fund (UNG). UNG holds the simplest of portfolios; next-to-expire futures on natural gas prices. UNG’s median daily premium/discount is a mere 0.04% because its arbitrage mechanism works perfectly.
In 2009, UNG’s rapid asset growth put it on a collision course with the fund’s position limits in the futures markets, which necessitated a halt in creations. While UNG’s portfolio managers scrambled to revise its prospectus and supplement its portfolio with natural gas-tracking swaps, market demand continued unabated. Because of the limited supply of shares, UNG’s market price spiked a premium, topping out at 19%. When UNG was able to resume creations, prices converged back to NAV.
ETF premiums jump when creations or redemptions are impaired. When issuer UBS halted creations of its ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (MORL-US) on September 6, premia followed immediately. Although these premia have subsided from their initial highs, they’re still not back to normal levels.
While these instances of price dislocation are rare, they are concerning and very real. Investors require tools that allow them to monitor impairments to the creation/redemption process, because these impairments create significant costs for ETF buyers and sellers.
The premium spikes we’ve seen are fully attributable to breakdowns in the creation/redemption process. Disturbing as these distorted prices are, they nevertheless confirm the power of the ETF arbitrage mechanism and competition among market makers. We will need to keep this in mind when we turn next to the case of ETFs where the arbitrage mechanism remains robust, but end-of-day premium/discount statistics show significant spikes on a daily basis.
At the time of writing, the author held no positions in the securities mentioned. Elisabeth Kashner is director of ETF research and analytics for FactSet.