The Indicative Value - Price Puzzle in ETNs: Liquidity Constraints, Information Signaling, or an Ineffective System for Share Creation?

Abstract

The prices of ETNs often significantly exceed their indicative values. Since ETNs share many features in common with zero-coupon bonds, this empirical finding is unexpected. (Adopting the language of Wright, Diavatopoulos, and Felton (2010), we refer to this as the negative WDFD puzzle.) Using a sample of 93 ETNs over the period June 6, 2006 to December 31, 2009, we explore three possible explanations for the negative WDFD puzzle. We find that the puzzle is not a result of liquidity constraints. In fact, increased trading volume is mildly correlated with more extreme mispricing in ETNs. We also find that ETN prices significantly exceeding their corresponding indicative values do not possess information about the future prospects of the asset, commodity, or index tied to the ETN. Instead, we conclude that the negative WDFD puzzle is the result of (1) uninformed, return-chasing investors and (2) an ineffective current system for creating new shares of existing ETNs. To work towards eliminating the negative WDFD puzzle, we recommend that ETN issuers restructure their systems for creating new ETN shares by allowing profit-motivated investors to initiate the process of share creation as they identify extreme mispricing in the market place.

Keywords: Exchange-Traded Notes, Exchange-Traded Funds, Tracking Error, Risk and Performance, Active Management

JEL Classification: G10, G11, G12, G14