Commodities: Energy Natural Gas
Investors often look first to size and liquidity as a first cut at picking the right ETP. In the Natural Gas segment, one product—UNG from US Commodity Funds—stands head and
“Lack of clearly superior alternative exposure helps to bolster the case for UNG” shoulders above the rest on both counts. UNG holds well over half a billion in assets and trades with extremely high volume. UNG offers plain-vanilla front-month futures exposure, which typically offers the best chance at capturing short-term movements in spot natural gas prices. The knock on front-month products is their heightened sensitivity to position decay from an up-sloping futures curve.
We looked for evidence that ETPs offering other types of exposure specifically designed to tamp down the effects of contango actually did the job. These include DCNG from Barclays and UNL from US Commodity Funds. DCNG only holds the December natural gas contract in an attempt to ward off the impact of seasonality. UNL uses a laddered approach with set months much further out on the curve beyond the front month.
Lack of clearly superior alternative exposure helps to bolster the case for UNG, but investors should know that as a commodity pool it has different tax rules than the ETN alternatives (DCNG and GAZ from Barclays). Lastly, those tempted to choose by lowest fee may not get what they expect. GAZ has the lowest fee at 75 bps, but costs from trading make it the most expensive choice, all-in. A breakdown in GAZ's basic plumbing (the create/redeem process) has created huge and persistent distortions to pricing in the marketplace and therefore to its returns. UNL, despite its commodities pool structure, gets our Analyst Pick due to its balanced exposure to the curve. (Insight updated 10/20/17)
ETF.com Efficiency Insight
Investors in natural gas ETPs must consider major differences in structures, asset levels, tracking and fees. These factors directly affect investor experience, and even ETPs with similar
“UNG utterly dominates in assets” scores differ significantly. The natural gas ETPs come in two legal structures: commodity pools and exchange-traded notes. UNG and UNL from US Commodity Funds and NAGS from Teucrium are commodity pools, so they issue K-1s to investors each year, with any gains marked to market and taxed as if investors sold their shares at year-end. There's no short-term/long-term distinction here—gains are taxed at a "blended" rate.
As ETNs, DCNG and GAZ from Barclays are taxed like equities and avoid K-1's. As debt instruments, ETNs aren't backed by futures contracts and collateral, but only by the credit of the issuing bank—Barclays in this case. We see low counterparty risk currently.
By size, the five ETPs fall into three groups. UNG dominates with over half a billion in assets. UNG was first to market in 2007 and its huge AUM tally signals long-term stability. The second tier of ETPs has a tiny fraction of UNG's size—GAZ and UNL have amassed AUM of a few tens of millions. Assets at this level bear watching—we currently see high closure risk for both funds. DCNG is yet another step down, with minimal assets, raising serious concerns about fund closure. (ETNs in dire straits would likely de-list rather than actually close.)
Tracking differences in the funds matter on their own, but also highlight other distinctions. GAZ's woeful record reflects that fact that it's been closed to creations for years. Meanwhile DCNG's tracking difference stems from its variable fee. The note's 85 bp fee is scaled by changes in the level of its index, variably growing and shrinking its lag. DCNG's fee is otherwise reasonable, if not the cheapest in the segment. GAZ is the cheapest, at 75 bps. UNL and UNG charge 132 and 82 bps, respectively. (Insight updated 10/20/17)
ETF.com Tradability Insight
Tradability is often proportional to assets under management. While this holds true in the Natural Gas segment, important caveats apply. US Commodity Funds' UNG dominates liquidity,
“the midpoint of GAZ's wide spreads may be nowhere near its fair value” just as it dominates AUM. The fund trades extremely well at all levels, with tight spreads. This kind of liquidity benefits investors of all stripes from the fast-money crowd to armchair dabblers in commodities. Ironically, the only chink in UNG's armor comes from its immense size: We see potential for UNG to halt creations due to CFTC position limits, something it has circumvented through the use of total return swaps in the past. Still, UNG remains the clear choice for investors requiring maximum liquidity.
UNG's sister fund UNL represents a major step down in liquidity, but careful investors can still trade it fairly with some effort. Well-placed limit orders can make this fund viable for longer-term investors.
Barclays' GAZ trades with fair volume, but its huge spreads signal another problem. GAZ's creations were suspended years ago, so the basic mechanism that all ETPs use to keep market price close to fair value is broken. Note that the midpoint of these wide spreads may be nowhere near GAZ's fair value.
DCNG's chief challenge is tiny volume—the fund can go days without trading at all, making it unsuitable for all but the most ardent believers in its methodology. (Insight updated 10/20/17)
ETF.com Fit Insight
All natural gas ETPs rely on futures contracts for exposure. Differences in futures selection rules are what set them apart. More importantly, each ETP's futures exposure has a huge
“UNG and GAZ offer the best sensitivity to natural gas spot prices” impact on performance.
Front-month ETPs—the most popular choice by assets—follow a simple set of rules. UNG and GAZ track the nearest contract to expiry—the front-month—and roll into the next month when the current month expires. This intuitive process offers perhaps the best sensitivity to daily changes in natural gas spot prices, the key to their popularity. The downside to this approach is extreme sensitivity to the shape of the futures curve. An up-sloping futures price curve (contango) spells trouble for long-term price performance.
Our GSCI benchmark uses front-month exposure, so one would expect very high scores from the two front-month products, UNG and GAZ. UNG indeed delivers a perfect score, indicating it delivers excellent exposure to front-month gas contracts (but not to spot natural gas, which is uninvestable).
Despite its front-month exposure, GAZ's score suffers because its actual pattern of returns differs greatly from that of our benchmark. The note's daily value is distorted by a longstanding halt in creations.
The other three choices here take a different path to futures exposure. GAZ's sister ETN, DCNG, aims to reduce decay from contango by holding the December contract (according to its rules) instead of simply rolling into the next month's. As such, DCNG's returns differ markedly from those of our benchmark. The note's "pure beta" moniker translates to low beta to our front-month benchmark. DCNG's 12-month returns beat our benchmark, but this relationship will continue to change going forward.
UNL, UNG's sister fund, tries to tame decay using a laddered approach. It holds contracts in equal weights dispersed across the 12 upcoming contract months. By design, UNL's performance varies greatly from front-month performance, which shows up as a low Fit score (and more specifically low beta). (Insight updated 10/20/17)