Last week saw another string of active sessions in commodity markets, with precious metals continuing their climb higher and agricultural ETFs soaring on supply concerns around the world. The most interesting performance of the week came on Friday, when the Teucrium Corn Fund (CORN) added more than 14% on trading volume ten times its daily average. The driver of the Friday rally was a supply-and-demand report from the United States Department of Agriculture (USDA) that conveyed sharper-than-expected reductions in estimates for corn supplies next year. The USDA projected 2010-2011 corn supplies below 1 billion bushels and projected stocks as a percentage of use at a 15-year low.
While the rally in corn prices was not surprising in the wake of the USDA report, the performance of CORN in Friday trading perplexed some investors. CORN, which invests in corn futures contracts across three different maturities, jumped by about 14.6% on the day, while prices of underlying corn futures added approximately 6% on the day. As a result, CORN finished Friday at $37.12, a premium to its net asset value of more than 8% [see Inside Five Surging Commodity ETFs].
Because CORN is a commodity pool, the underlying infrastructure of the fund includes the same creation/redemption mechanisms that generally prevent ETFs from trading at a meaningful premium or discount to the net asset value. If the price of the fund exceeds the net asset value of the underlying assets, market participants will create additional units by exchanging a basket of component securities, generating an arbitrage profit in the process. But at first glance it appeared that this mechanism broke down for CORN on Friday, as ETF investors unaccustomed to significant NAV gaps suddenly saw a premium wide enough to drive a truck through.
The explanation for the significant premium, however, actually had nothing to do with CORN’s efficiency. There is a 30 cent maximum daily move imposed on corn futures on the Chicago Board of Trade, and Friday’s news quickly sent the commodity up to that threshold, essentially ceasing activity for the day. Because CORN isn’t subject to the CBOT limitations there was no cap to the fund’s price on Friday, and investors quickly turned to the corn fund as a way to continue making bets on corn prices. Clearly, the consensus opinion was that the USDA report justified a price increase of more than 30 cents, and CORN became an effective and efficient tool for investors to bet on corn prices even after trading in the underlying futures had effectively been halted [also see Corn ETF Continues Mind-Boggling Rally].
More than 200,000 shares of CORN traded hands on Friday, about ten times the average daily volume. So clearly the huge premium to NAV to end the week was not a result of insufficient liquidity, but rather the fact that CORN emerged as one of the only options for investors looking to bet on corn prices during Friday trading. Because trading in corn futures was effectively halted after the daily limits were reached on Friday, the prices of CORN’s underlying securities were not reflective of the market’s views on price. So it was not CORN’s price that was disconnected from its fair value; rather, the NAV wasn’t a meaningful indicator of the market price for corn futures.
Several other commodity ETPs closed at a premium to NAV on Friday. The PowerShares DB Agriculture Fund (DBA), which has more than $2 billion in assets and average daily volume of 1.5 million shares, finished the day at a 2% “premium” to NAV. The iPath Dow Jones-UBS Grains ETN (JJG) closed more than 3% above its calculated NAV. Again, there was no breakdown in any of these products–the disconnect resulted from the limits in trading on underlying securities, which resulted in posted prices that weren’t reflective of the market’s take [for more on this story see Behind A Blockbuster Friday For Commodity ETFs].
The Day After
On Monday, the daily limit for movement in corn futures was expanded to 45 cents, and December contracts rallied another 8.5% to touch two year highs. The rally wasn’t driven by any new information, but rather reflected the price movements that would have occurred on Friday had limits in single-day swings not been in place on the CBOT. CORN, however, actually lost 4% on the day as investors apparently expressed that the impact of the report may not have been as significant as originally expected.
Friday’s events highlighted a potential use of commodity ETFs as vehicles that provide a continuation of trading activity even after intra-day limits have been tripped on the related futures exchange. The tripping of the intra-day price limits actually didn’t stop trading in corn futures, but rather kicked the can further down the road as activity moved to exchange-traded products offering exposure to the commodity. In recent weeks it seems that the media has pounced on every opportunity to attack ETFs. While Friday seemingly raised additional red flags, the reality was that commodity funds performed exactly as they should have, and in fact added valuable liquidity to what would have otherwise been a temporarily illiquid market [also see The Perfect Storm For The Corn ETF?].
Disclosure: No positions at time of writing.