Investors trained to believe that exchange traded funds don't trade at premiums or discounts to their net asset value might be in for a surprise.
Three ETFs that short an underlying index of financial stocks have halted share creation, which means they may end up trading at unusually wide premiums or discounts to their net asset value once trading resumes, said Matt Hougan, editor of indexuniverse.com of New York.
As a result, investors may unwittingly jump into the ETFs — two from ProShare Advisors LLC of Bethesda, Md., and one from Rydex Investments of Rockville, Md. — at a premium, only to realize that they have overpaid when the ETFs once again start to create new shares.
It's the creation-redemption process that causes ETFs to trade at or near NAV.
The situation developed because ETFs stopped creating new shares, a result of the emergency action announced by the Securities and Exchange Commission on Sept. 18 that temporarily prohibited short sales of shares of certain financial companies until this Thursday.
SWAPS AND OPTIONS
The ProShares UltraShort Financials ETF (SKF), ProShares Short Financials ETF (SEF) and Rydex Inverse 2x S&P Select Sector Financial ETF (RFN) don't short stocks themselves. But ProShares ETFs rely largely on swaps to get short exposure, while the Rydex ETF largely uses options.
It was assumed by many industry observers that counterparties would not be willing to write swap agreements, because they would be unable to hedge away the exposure. And the SEC ban on short selling originally extended to the options market.
The commission quickly reversed itself, granting option market makers permission to sell stocks short to support their market-making activities.
The Rydex ETF, however, had not resumed sales as of Sept. 23.
The fact that ProShares had stopped sales of the two ETFs did not mean there was a problem with its ETF structure, said Michael Sapir, chief executive of ProShares and its sister company, ProFund Advisors LLC, also of Bethesda.
"This unprecedented action by the SEC has limited the ways that investors can get short exposure to financials, so we were concerned we would be inundated with requests to create new shares," he said.
Given that there would likely be few counterparties willing to write new swap agreements, it would have been difficult for ProShares to keep up with the demand, Mr. Sapir said.
There also is nothing wrong with the Rydex structure, said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm that manages $75 million in assets.
"If you're sophisticated enough to consider a short or leveraged ETF, you understand that ... there are certain limitations," said Mr. Lydon, who is also a director at Rydex.
That may be true, but there is still the possibility that an unsophisticated investor may decide to take a chance on the ETFs and get burned, Mr. Hougan said.
It's hard to believe no one lost money in the iPath MSCI India exchange traded note (INP), issued by Barclays PLC of London, when it temporarily halted new creations, he said.
The reason the ETN — a note backed by Barclays that trades in much the same way as an ETF — halted share creations was because of restrictions the Indian government placed on foreign investment in 2007, Mr. Hougan said. As a result, it traded at a very large premium, hitting 15.77% Nov. 30.
"Anyone that bought it at a premium got clobbered because it came back to NAV," Mr. Hougan said.
It's unlikely the ProShares and Rydex ETFs, however, will ever see premiums as steep as those seen in connection with the India ETN, said John Gabriel, an ETF analyst with Morningstar Inc. of Chicago.
"I don't think we're going to see that kind of divergence here," he said.
The markets have already had time to adjust to the fact the ProShares and Rydex ETFs are not creating new shares, Mr. Gabriel said. It's why all three were trading very close to their NAV, he said.
"My impression is, the shareholders will come out OK," said Marvin Appel, chief executive of Appel Asset Management Corp., a Great Neck, N.Y., firm that manages $50 million in assets.
It may cause some investors to think twice before buying an ETF that shorts an underlying index, but there will probably still be demand for such investments, he said.
E-mail David Hoffman at [email protected].
