Commodity ETFs Face Zero-Sum Game

August 27, 2009

Is there a way for investors to avoid playing with fire as commodity ETFs choose to close rather than face new restrictions?


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


The decision by regulators to impose position limits on two of Deutsche Bank’s agricultural exchange-traded products last week has led to a number of funds choosing to close.

Among the casualties so far are the: DB Crude Oil Double Exchange-Traded Note (NYSEArca: DXO); iShares S&P GSCI Commodity Index Trust (NYSEArca: GSG); iPath Dow Jones-AIG Natural Gas ETN (NYSEArca: GAZ); and United States Natural Gas Fund (NYSEArca: UNG).

The funds that've temporarily stopped issuing new creation units can technically be considered as remaining open since each still accepts redemptions. But in halting issuing of new creation units, managers are effectively cutting off their pipelines to new investments. (See related story here.)

And more ETPs, even those in the hard assets sectors, are likely to follow suit as the U.S. Commodity Futures Trading Commission and other regulators clamp down on what they perceive as an industry run wild.

Bigger Premiums Coming

While using swaps contracts serves as mere Band-Aids for the moment due to their limited availability, some might be forced to tender back their shares if the CFTC finds them to be already over their position limits, argue others.

Unless there is a sudden exodus of investors, without the ability to increase the number of shares, the funds will end up looking nothing like the products they were designed to deliver to investors. Instead, they will resemble closed-end funds rather than pure ETFs.

SeriesIconIf the ETFs are allowed to maintain their current position limits, and are not forced to sell assets or scale back their core holdings, the shares of funds such as the United States Oil Fund (NYSEArca: USO) and SPDR Gold Shares (NYSEArca: GLD) might trade at a premium to the actual commodity price as investors weather the extra costs of investing in order to take advantage of short-term price movements.

This is the case right now with UNG and GAZ. Earlier this week, the funds were trading with premiums of around 16% and 12%, respectively, above the net asset value of the natural gas futures contracts they currently hold.

“We could see a lot more situations where [the funds] drift from their NAVs from time to time as they hit any limits that wind up being imposed,” said Tom Lydon, president of Global Trends Investments. “It might be a risk that investors will just have to accept may happen if they decide that they want to be involved in these markets.”

Commodity Price Manipulation

The big problem with an ETF premium is the result it has on the price of the underlying commodity. If, for example, retail investors are willing to pay 10% more for gas than the value of its futures contract, then that in turn may incentivize futures traders to bid up or bid down the price of gas without any regard to the economic reality underlying it.

Just as mortgage-backed securities propelled house prices to unsustainable highs, so might commodity ETPs create a synthetic—and unrealistic—valuation for certain assets.

Eliminating much of the premium that commodity ETFs increasingly incur is a key goal of the CFTC, since proprietary institutional traders usually end up benefiting without passing on any of the gains to the retail investor. In that case, tendering back the shares might become the only possibility.

That action would likely create downward pressure in the commodity prices and in the value of the ETPs, as values of the shares readjust to the new position limits and the energy markets are flooded with more supply.

“If the funds have to cut position limits on already-issued shares, then theoretically, people who owned shares will be uncovered on a portion of their position,” said Paul Mendelsohn, chief investment strategist at Windham Financial in Virginia.

Mendelsohn has both proprietary and discretionary positions in UNG, but remains relaxed about the pending CFTC regulations, however. “I’m not sure the CFTC really wants to penalize the investors who use these products,” Mendelsohn said.

But Bradley Kay, an ETF analyst with Morningstar in
, points out that investors might be playing with fire by buying funds that are already unable or unwilling to issue more shares.

“To a great extent, investors shouldn’t really be chasing funds that are closing,” said Kay. “Once a fund is large enough to be hitting position limits, that means they’re taking a distortionary long-only position that is utterly transparent to every other market participant.”

In other words, as investors pay a premium to buy the commodity and the fund loads up, institutional traders can easily take advantage of that position and push the price of the underlying asset down. Kay added that USO and UNG are “by far the largest sources of distortion.”


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