What’s Next For Commodity ETFs?

August 26, 2009

As regulators increase their focus on the sector, advisers and money managers are putting several well-known funds on their watch lists.


Editor’s note: The following is the first installment in a two-part series looking at the fallout of the ongoing regulatory probe into commodity-focused exchange-traded products. (See part two here.)


Just as commodity prices are finally showing signs of life, many investors in exchange-traded products focusing on everything from oil to precious metals are fretting over the impacts of regulatory clampdowns.

Nobody knows how long the ongoing debate will rage in
Washington, D.C. But the longer federal authorities take to decide whether to place limits on commodity investments, the more likely it becomes that a greater number of ETPs will be forced to act like close-end funds.

Exactly which products those will turn out to be remains unclear. Still, several prime candidates being mentioned within the industry?both in institutional as well as individual advisory circles?include a number of well-known ETP names. (The all-encompassing ETP category covers traditional exchange-traded funds and exchange-traded notes as well as hybrid commodity pools and other sophisticated open-end funds that trade on exchanges.)

Prime candidates some advisers and institutional money managers are putting on their watch lists right now include: The United States Heating Oil Fund (NYSEArca: UHN); the United States Oil Fund (NYSEArca: USO) and the PowerShares DB Energy Fund (NYSEArca: DBE).

Further down the line, there is even speculation that the SPDR Gold Shares (NYSEArca: GLD) and the iShares Silver Trust (NYSEArca: SLV) may come under scrutiny by the U.S. Commodity Futures Trading Commission and the Securities and Exchange Commission.

The amount of precious metal these funds hold rivals that of central banks. GLD, for example, holds $32 billion of gold?more than many emerging market central banks, including Malaysia, Bulgaria, Mexico, Peru and even

Swaps Only A Short-Term Solution

One way in which these funds might try to circumvent CFTC regulations is to enter into swaps contracts. Such a move could allow ETP firms to dodge their position limits on holding the raw commodities. For instance, last week the U.S. Natural Gas Fund (NYSEArca: UNG) entered into a $500 million swap. (See related story here.)

Using swaps contracts enables an ETF to enter into an agreement with a market counterparty (for a fee), whereby it agrees to pay or to be paid the difference in the value of the commodity at the end of a specified period. In this way, UNG can still replicate the performance of the price of natural gas without actually holding any gas itself.

But swaps contracts are only available in limited sizes, and right now they don’t seem like a long-term solution to expanding the size of an ETF aiming to track the price of a single, widely traded commodity, such as gas.

John Hyland, chief investment officer for United States Commodity Funds, which manages the UNG, said in a statement this week that “these natural gas-based swaps are not enough by themselves to allow us to either meet what we think such potential CFTC levels might be, or to permit us to prudently allow new creations.”



A Spate Of Downsizing

The other problem with relying on swaps contracts to build the funds is that the CFTC is unlikely to overlook them when it comes to making a final decision on the rules regarding commodity ETPs, says Bradley Kay, an ETF analyst with Morningstar in

“My feeling is that a lot of tricks UNG used will be addressed by the CFTC,” said Kay. “It would be a little silly for the CFTC to come down very hard on position limits and ignore the loopholes, since that means it no longer matters how large the fund gets.”

Barring further use of swaps, the managers’ only options are likely to be how to limit the growth of, or even downsize the funds. USCF’s Hyland admitted this week that “at the far extreme,” making UNG smaller would be the only remaining option.

If position limits are set prior to their current levels, funds will be forced to either sell assets to cover their newly reduced limitations, or possibly, to issue a tender offer for their own shares. The consequences of that action are still unpredictable, but they are possibly dire for many of today’s rallying commodities markets.

Adding Some Perspective

In the past week, the problem of issuing new shares for commodity exchange-traded products has been rapidly building to a head, but it first started in April. Back then, investors began snapping up shares of the UNG, an ETF linked to the price of natural gas, as they bet on a big rebound in the price of the commodity after the first signs of green shoots began to appear in the global economy. (See related story here.)

Unfortunately for investors in UNG, regulators were not so forthcoming in handing out approval of further share issuances. While they mulled the decision, UNG began to show signs of trading at a slight premium to the price of natural gas, as investors cast aside fears of overpaying for the underlying commodity in preference for having exposure to it.

More commotion began last week when the CFTC announced it was revoking exemptions to the creation of position limits in agricultural commodities by the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC) and PowerShares DB Agriculture Funds (NYSEArca: DBA). That decision prompted a temporary halt in the issuance of new shares on the PowerShares DB Crude Oil Double ETN (NYSEArca: DXO) a day later. (See related story here.)

Monday, Barclays Global Investors followed suit, and said it was issuing a halt to the creation of new shares of its iShares S&P GSCI Commodity Index Trust (NYSEArca: GSG) product once the outstanding number of shares reached 55.9 million. The total outstanding shares for GSG is approximately 52 million right now. The iPath Dow Jones-AIG Natural Gas (NYSEArca: GAZ) also intends to stop issuing new shares once it hits its position limit. (See related story here.)

“[Fund providers] don't want to be caught in a spot where they have to unwind positions in order to come in under any limits. It appears that they’re being prudent?causing a little hassle now to save a lot of hassle later,” said Tom Lydon, president of Global Trends Investments. “We could continue to see more and more funds do this up until the CFTC makes an announcement.”

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