Dollar Contrarians Move Too Fast for the SEC

Another month in ETF land, and another fund runs into high-profile problems. PowerShares DB US Dollar Bullish (UUP) stopped issuing new shares today, Nov. 5, and even ceased trading for 45 minutes of the afternoon. These developments may start alarm bells ringing for those who paid attention to the troubles with commodity ETFs earlier this year, or short financial ETFs last year, but this time it really is different (and we say this with all due respect to the late Sir John Templeton). We're not especially concerned about this temporary fund closure, and neither should you be, whether you are an investor in UUP or just wondering what it might imply for the broader market.

Previous ETF closures and trading halts have been caused by massive market dislocations and regulation. As the underlying investments faced severe restrictions, ETFs had to stop issuing new shares. PowerShares DB US Dollar Bullish had no such problems. The foreign exchange futures market is exceptionally liquid. Amounts larger than the total assets of UUP frequently trade with nary a ripple in the market for its underlying currencies: euros, yen, pounds, Canadian dollars, Swedish krona, and Swiss francs. Instead, an exceptionally fast surge of assets and slow response from an overburdened SEC pushed the PowerShares ETF into a rarely noticed share limit.

Whenever an ETF is first registered, the SEC registers an initial number of shares for issuance, and the remaining shares under that legal limit appear in the prospectus filings as the number of Common Shares of Beneficial Interest (as seen here in the PowerShares DB US Dollar Bullish prospectus from May 1 of this year). This limit is not unique to ETFs; public companies in the U.S. also register the number of common shares that they may eventually issue. Normally, these statutory limits are irrelevant for shareholders, as the ETF trust or public company has approval for a vast number of shares. Otherwise, as assets start to approach the limit of registered shares, the ETF provider submits an S-3 filing to the SEC requesting permission for more shares. After paying a small fee and garnering quick approval, the ETF provider updates the prospectus, and the fund has room to grow. Investors and the market rarely even notice, as this process typically functions so smoothly.

Unfortunately, the PowerShares ETF had a recent influx of interest beyond nearly anything we've seen in such a specialty ETF, and clearly more than PowerShares itself expected. At the end of August this year, UUP had only $350 million in assets. That jumped to $500 million by the end of September, $550 million just two weeks ago, and $730 million by last Friday. On Tuesday of this week, PowerShares filed its S-3 with the SEC to declare that it had a limited number of available shares remaining and to register 100 million new shares, which would expand its potential asset size by roughly $2 billion at today's prices. However, the asset growth continued apace. By noon on Nov. 5, PowerShares DB US Dollar Bullish hit $880 million in assets and 40 million shares outstanding--its current registered limit.

SEC approval should come soon, as this filing should come to the top of its towering work pile. Until then, we do not expect much premium to develop on the existing shares, nor any further trading disruptions. Because the underlying futures still trade freely and without any relevant position limits, any institutions owning UUP will gladly sell at a tiny premium and replace it with the underlying currency futures. Otherwise, arbitrageurs will step in and short UUP to keep it close to fair value, as the extremely likely approval of new shares will allow them to create new shares and cover their short positions soon. This ETF may have looked like a new victim of this year's crazy markets, but it actually hit little more than a minor speed bump. (The 1.5% premium that developed after trading resumed at 1:45 p.m. had already disappeared by the 4:00 p.m. market close.) This is yet another example of the ETF structure's oddities, which shows we haven't ironed out all the details after all these years, but it's also a sign of the structure's robustness in the face of disruption, whether from markets or regulations.

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