Race to Short Natural Gas Has Investors Pouring Into Risky ETNs

(Bloomberg) -- The largest exchange-traded note tracking the natural gas industry is down more than 60 percent this year, but that isn't hurting investors' insatiable demand for it.

As the Credit Suisse Group AG's VelocityShares 3x Long Natural Gas ETN, better known by the ticker UGAZ, has plummeted this year almost $640 million has flowed into the note while shares outstanding have soared around 442 percent to 38.1 million, according to Bloomberg data. The demand is coming from short-sellers eager to profit from a phenomenon that causes the price of leveraged products to plummet almost like clockwork.

“It's just math, and math says the price is going to head toward zero,” said Chris Abraham, chief investment officer of CVA Investment Management, who is shorting both UGAZ and its twin, the VelocityShares 3x Inverse Natural Gas ETN, which goes by the ticker DGAZ.

Leveraged exchange-traded products like UGAZ typically reset daily to give new buyers the performance they anticipate, which in the case of UGAZ is roughly three times the return of the S&P GSCI Natural Gas Index. However, because of this daily resetting, the longer investors hold them the less accurately they track their benchmarks because the purchase was made at a different time. In particular, when markets are choppy, the price of leveraged ETPs is all but certain to plunge in a phenomenon known as “volatility drag.”

Volatility drag is caused by fluctuations in the prices of assets in a portfolio. Essentially it's a mathematical formula that shows when values bounce around, the compounded amount of actual generated wealth turns out to be less than the calculated average return. The best way to see the phenomenon is over a long time frame.

For example, both of the Credit Suisse ETNs track the same index, but from different directions -- UGAZ is designed as a bullish portfolio, while DGAZ takes a bearish position. The bullish ETN would be expected to perform poorly over the past few volatile years, which it has, losing 99.55 percent of its value since March 2012. But the bearish portfolio also has taken a huge hit, falling more than 92 percent over the same time period.

“The volatility drag will make both go down, even if during that time period natural gas goes up or down,” said Eric Balchunas, an ETF analyst for Bloomberg Intelligence.

Short Demand

This dynamic makes the ETNs attractive to short-sellers. The number of UGAZ shares sold short climbed to 3.1 million on March 6 from 122,000 on March 9, 2016, according to data compiled by IHS Markit Ltd. DGAZ shares sold short soared to 26.2 million on March 6 from 683,000 on March 9, 2016, IHS Markit data show.

Meeting the demand from shorts is one reason why share numbers are climbing even as the price of both notes drops, said Sebastian Mercado, a strategist for ETFs at Deutsche Bank AG. Last year, the cost to borrow shares of the ETNs was around 3 percent, while this year it's climbed to around 6 percent, he said. As borrowing costs increase, “more people are going to be interested in lending securities out.”

A popular “double short” last year involved short selling shares of leveraged oil ETNs UWTI and DWTI as the price of crude bounced around.

Of course, the strategy is not without its risks. If markets calm down and the prices of the products move in a straight line, volatility decay becomes less of an issue. The trade is also effective only if traders commit to holding these highly-volatile products for an extended period of time, Mercado said.

“The decay works in the very long-term,” he said. “But the ride to get there could involve some trends or spikes that might make you lose all your capital.”

To contact the reporter on this story: Carolina Wilson in New York City at cwilson166@bloomberg.net.

To contact the editors responsible for this story: Yakob Peterseil at ypeterseil@bloomberg.net, Jeremy Herron at jherron8@bloomberg.net, Eric J. Weiner