The U.S. Natural Gas Fund (UNG), which has been in the news constantly as the CFTC weighs its options for curbing what it deems to be excessive speculation in the commodities markets, continues to defy the tenets of rational investing. The fund opened Monday at a 20% premium to its net asset value, meaning that the market value of all outstanding shares was about 1.2 times the market value of the fund’s underlying assets. Regardless of the next steps taken by the CFTC or the future of regulation in the commodity industry, the current premium on UNG is not sustainable, and any logical investor with an interest in UNG would be well served to liquidate his or her position.
Behind most exchange-traded funds is an arbitrage mechanism that prevents market prices from deviating from the net asset value of a fund’s underlying holdings. Since the assets underlying most ETFs are securities traded in the open market, if a material disconnect arises between an ETF and its net asset value, an arbitrage opportunity will arise and quickly be exploited by large market participants.
On the Eighth Day…
Most investors don’t take time to think about where shares of ETFs come from, but this creation process is crucial to maintaining liquid, constant markets for these securities. For most funds, new shares will be issued to Authorized Participants (APs) in exchange for a specified portfolio of equities comprising the index underlying the ETF. Generally, shares are issued in blocks of 50,000, thereby limiting the universe of investors able to participate in this creation process. Likewise, most ETFs can be redeemed (in groups of 50,000 shares) in exchange for a basket of stocks that approximates the holdings of the index on which an ETF is based.
So where did this process break down in the case of UNG? First of all, UNG is a commodity pool, which means that the creation process is slightly different. Most notably, UNG must receive approval from regulators before issuing new shares at certain levels. As the number of investors looking to make a play in natural gas surged earlier this year, UNG quickly hit one of these share thresholds, and filed for approval on additional share creations with the SEC.
Rather than approve the request in a timely fashion, the SEC delayed its decision (which is very different than denying the request) for some time, perhaps waiting for the Commodity Futures Trading Commission to come to a decision on potential regulations for the industry. The CFTC became concerned earlier this year that ETFs providing exposure to “commodities of finite supply” (basically oil and gas funds) were facilitating speculation in these markets. Such behavior would leave the potential for increased volatility and prices that don’t necessarily react to fundamental supply and demand data.
It is widely anticipated that the CFTC will establish position limits, which (as one might guess) limit the number of futures that any single investor or fund may hold. But exactly what the position limits will be remains to be seen. The fear at UNG is that the fund in its current state will exceed the CFTC’s limits. For this reason, UNG has held off on issuing more shares, even though it did ultimately receive SEC approval to do so.
Where Do We Go From Here?
The future of commodity ETFs is murky at best, but it’s becoming increasingly difficult to imagine a scenario that justifies paying for a 20% premium on UNG. Matt Hougan at Index Universe recently authored an excellent article postulating on the performance of UNG under five of the most likely scenarios. Some of these scenarios would result in either an immediate or gradual dissolution of UNG’s premium to NAV, which is bad news for current investors. But then again, Mr. Hougan penned this piece when the premium was around 11% two weeks ago. It’s since nearly doubled (the premium to NAV that is), rewarding those who decided to hold on to UNG.
Even if position limits do limit the creation of additional shares and “justify” a premium to NAV, I have a hard time believing that the premium will stay at its current level for long. Closed end funds, which lack the efficient arbitrage mechanism of ETFs, rarely trade at a premium or discount of more than 500 basis points. Moreover, innovation in the financial space is nothing new (as evidenced by the development of the ETF industry). If demand for natural gas investments continues to outpace supply by such a wide margin, we can expect that additional funds, or perhaps new investment vehicles altogether, will pop up to satiate the demand.
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Disclosure: No positions at time of writing.