Don't gamble with this natural-gas ETF's premium

The fund has become increasingly disjointed from its underlying index, so just watch it from the sidelines for now.

By TheStreet Staff Apr 5, 2011 11:23AM

By Don Dion, TheStreet

 

In view of rising oil prices and souring sentiment toward nuclear energy, natural gas is back in the spotlight, driving investors into ETFs and exchange-traded notes targeting the attractive fuel source.

 

The sudden spurt of popularity has created an alarming, albeit interesting, scenario for one of these products, the futures-based iPath Dow Jones UBS Natural Gas Subindex Total Return ETN (GAZ).

 

As investors have poured into the product, GAZ has become increasingly disjointed from its underlying index. This has resulted in the development of a substantial premium that stood at nearly 18% as of April 1.

 

This inflated premium is due to the fact that no new shares of GAZ are coming to market at this time. In the latter half of 2009, in order to keep the fund from breaching limitations set by industry regulators, GAZ's managers intervened on the fund's creation/redemption process, capping its size.

The recent popularity of GAZ has caused the fund to expand and once again bump against the limitations set up by its managers. Unable to issue new shares to satisfy the heavy investor demand, the fund has essentially begun to trade like a closed-end product.

 

This is far from the first time that the pricing of an exchange-traded fund has been tampered with, resulting in the creation of a substantial premium. In fact, earlier this year, investors witnessed a similar divergence in the Market Vectors Egypt ETF (EGPT).

 

After spending much of its time flying under the radar, EGPT got a jolt of popularity as Egyptians took to the streets in early 2011 to protest the nation's government. In response to the increasing unrest, the Egyptian government decided to shut down its stock market. In the wake t of the closure, EGPT's sponsor, Van Eck, announced that share creation would be halted until the market was reopened.

 

As with GAZ, heavy investor demand, coupled with a halted share-creation mechanism, caused EGPT to break away from its underlying index, resulting in the inflation of a substantial premium. Weeks later, when the Egyptian market was at last reopened and EGPT was restored to normal operations, the fund's premium was wiped out. As the fund fell back in line with its underlying index, investors left holding EGPT were sent for a wild ride.

 

You can see influence a staggering premium can have on a fund's performance by comparing GAZ's recent action with that of fellow futures-based natural-gas ETF the United States Natural Gas Fund (UNG). Although it has struggled with premiums in the past, at this time UNG is trading relatively in line with its underlying index. Both funds are designed to target the price changes of natural-gas futures. However, year to date through April 1, UNG is down 5.4%. GAZ, meanwhile, has jumped more than 10%.

 

GAZ's premium-influenced action will be watched closely in the weeks ahead, but this is not a fund I would encourage investors to try their luck with. In order to avoid the possibility of suffering through an EGPT-like shakeup, investors should monitor GAZ from the sidelines only. The fund's action is unpredictable and therefore inappropriate for investors looking for ways to accurately track the performance of natural-gas prices.

A more suitable option for natural-gas bulls is the First Trust ISE Revere Natural Gas Index Fund (FCG). Rather than tracking futures contracts like GAZ and UNG, this fund tracks a basket of companies involved in the discovery and production of natural gas.

 

TheStreet contributor Don Dion runs Dion Money Management. At the time of publication, Dion Money Management owned First Trust ISE Revere Natural Gas Index Fund. 

 

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