EXCLUSIVE TO SIGHTLINEU3O8 – For the uranium investor that was long in February and March of this year, the sudden uranium equity price drops and general volatility may have been surprising. With price drops of almost 30% in some equities, uranium investors were undoubtedly taken by surprise.
The February/March drop was largely caused by changes announced by the Global X Uranium ETF (NYSE:URA). URA is the only large ETF available directly targeting the uranium space with a mandate to offer diversified exposure to a broad range of uranium mining companies.
With a recent adjustment in philosophy resulting in a rebalancing of the ETF’s ~USD$375 million in net assets, there may be more volatility on the horizon.
What is an ETF?
Think of an ETF as a slice of a pool of securities or a more liquid mutual fund. While both financial instruments are comprised of multiple underlying securities, a mutual fund settles at market close whereas an ETF is transactable at any point during market operation.
As such, the value of an ETF is derived from the individual values of its underlying securities. Every ETF has a mandate, describing the criteria used to select its underlying securities and the fixed percentage of total net assets that each security is allocated. The simplest ETFs mirror a popular market index, like the S&P500 or the FTSE however, ETFs can also get quite complex employing leverage, futures trading, and derivates to achieve a very specific result.
Regardless of the tactics and complexities employed to structure an ETF, the benefit to the long investor is exposure to underlying assets in a specific sector, geography, commodity, index, etc.
How is Liquidity and Fair Pricing Accomplished?
Intraday liquidity is possible because of the role played by market makers (also called authorized participants or APs for short). These APs are large institutional investors that facilitate the creation and redemption mechanism essential to ETF liquidity and fair ETF pricing; fair meaning ETF prices reflective of underlying exposure / assets.
Think of APs as intermediaries between the secondary market and in this case, the issuer, Global X. Only APs can transact with the fund due to the sheer size of these transactions. An AP can give the fund a bucket of securities in exchange for ETF units or, vice-versa, give the fund ETF units in exchange for securities.
When investors buy an ETF, demand increases moving the ETF price higher than its underlying assets and thus creating an arbitrage opportunity. To take advantage of the opportunity APs will:
- buy more underlying assets from the secondary market
- exchange the bought underlying assets with the fund for more expensive ETF units
- sell more ETF units on the secondary market
- pocket the difference between underlying assets bought and ETF units sold
Execution of this process has the following effects:
- demand for underlying units is increased driving individual securities prices up
- supply of ETF units is also increased driving ETF prices down
Full equilibrium is never reached but execution of the arbitrage ensures ETF prices trade very close to the values of their underlying assets.
When an ETF trades at a discount to its underlying assets due to investors selling ETF units, the process occurs in reverse. APs will buy ETFs from the secondary market to trade for underlying assets with the fund. These assets are subsequently sold on the secondary market.
More simply put, ETF purchases result in underlying asset purchases while increased ETF sales result in underlying asset sales.
Why is the URA Being Changed
The URA tracks the Solactive Global Uranium Total Return Index (SOLURA for short) which is comprised of companies active in the uranium mining and exploration industry. As of July 2018, the SOLURA index will be replaced with the “Solactive Global Uranium & Nuclear Components Index.”
The new index broadens exposure to the nuclear industry as a whole as opposed to reliance on only uranium mining and exploration companies. As a result, companies with operations related to the production of nuclear components and technologies will be scoped in.
A summary of target weightings for both indices is included below:
With supply cuts in place, some EPS volatility in miners’ results are to be expected. To smooth this out, the new Index increases diversification, emphasizing large-cap Asian manufacturing companies to take advantage of the growing nuclear fleets in those regions.
What do URA Changes mean for Underlying Security Prices and Volatility
There are two ways an ETF can affect the prices of individual securities:
- Demand and Supply of ETF – meaning purchases and sales in the ETF ultimately result in purchases and sales in its underlying securities. This creates an additional layer of buying and selling alongside the direct transactions between investor and individual securities on the secondary market. Thus, securities that are part of an ETF generally enjoy greater liquidity and transaction volumes due to the role played by APs.
- Rebalancing – when an ETF investment mandate/ asset allocation changes, so does its underlying asset allocations. This results in additional buying and selling on the secondary market to facilitate the rebalancing.
Rebalancing usually takes place in phases to ensure lower volatility in the ETF’s price. Unfortunately, it always has the effect of artificially displacing the prices of the underlying securities being changed. Phase 1 of the URA rebalancing resulted in the equity price volatility during February/ March.
There are more phases required to transition the old SOLURA Index to the new one. Asset allocations as of Phase 1 completion are summarized below:
As can be seen, the stake in Uranium mining companies has dropped and will continue to do so. Further rebalancing is needed and will result in additional volatility for the mining companies whose fund percentage allocation is being changed.
What Does this all Mean for Uranium Investors
Over the past 4 months, there have been a number of significant events that should directly affect the price of uranium, ranging from mine shutdowns to soviet sanctions and Japanese reactor re-starts. For investors looking to take advantage of a pending rise in uranium prices, they must take into account the impact of the URA:
- The Phase 1, URA rebalancing significantly contributed to the uranium equity volatility observed in February and March as it announced and then executed the sell-off of certain of its uranium equities.
- Since the URA’s future intended asset allocation is yet to be achieved, there will be additional phases of rebalancing causing further volatility in the equities being transitioned. For the volatility adverse investor, it may be prudent to stay away from the companies being transitioned, at least in the short term.
- For those using the URA as a method of investing in uranium, there is some downside to the proposed asset allocations in the Solactive Global Uranium & Nuclear Components Index caused by potential over-diversification cutting into the returns of a uranium price resurgence. Some of the new companies being added have highly diversified operations that are not solely concentrated on uranium thus, they would capture a lower percentage of a uranium rally.
- The miners and explorers that stand to benefit the most from increasing long-term prices are potentially under-represented under the new Solactive index due to the focus on lower volatility and the entire nuclear industry.
Investors should continue to maintain a broad balance within their uranium portfolios if they expect to maximize their exposure to the metal while keeping a responsible handle on their investment risk.
