Commodity Investing: Only For “Oil Companies and Morgan Stanley”?

by on August 24, 2009 | ETFs Mentioned:

The tremendous growth rates experienced by the ETF industry over the last two years have largely been viewed as a huge win for individual investors. The rise in popularity of indexing as an investment strategy and introduction of hundreds of new exchange-traded products has allowed smaller players to take control of their own portfolios, slashing expenses in the process. But it appears that certain areas of the ETF industry may have expanded too rapidly, and the backlash is now being felt by the market’s smallest participants.

Natural Gas Processing PlantCommodity ETFs, which were introduced in 2003, had more than $59 billion in assets at the end of July according to data from the National Stock Exchange. Commodity exchange-traded products have seen inflows of more that $22 billion to date in 2009, drawing the attention of regulators who are concerned that commodity ETFs are contributing to increased speculative behavior and distorting market prices. According to the Wall Street Journal’s Brian Baskin “some say this causes runaway buying that ignores bearish signs that more knowledgeable investors and commercial hedgers usually heed.”

The Commodity Futures Trading Commission has begun conducting hearings into the role that speculators are playing in the commodity markets, a move that many anticipate will lead to position limits on ETFs. The U.S. Natural Gas Fund (UNG) offered by U.S. Commodity Funds, has already been significantly impacted by the prospect of new regulation. The fund recently announced that it won’t issue new shares (despite finally receiving approval from the SEC to do so) since it already owns about a fifth of certain benchmark contracts, which may be greater than new limits would allow.

The inability of UNG to issue new shares has caused the fund to act more like a closed-end fund than an ETF. Recently, UNG was trading at a premium of more than 15% over its NAV as investors were willing to pay extra to gain exposure to natural gas. ETFs traditionally trade within a few basis points of their NAV, as a result of the underlying mechanisms that allow certain investors to profit if prices move away from their intrinsic value. While the ultimate resolution of the UNG situation is uncertain, Matt Hougan at Index Universe points out that most scenarios will be bad for current UNG investors.

Bad News For The Little Guys

The implementation of position limits is a blow not only for UNG, but for individual investors as well. “What you’re really saying is the only people who should be allowed to trade crude oil are oil companies and Morgan Stanley,” said John Hyland, chief investment officer for UNG, to CFTC commissioners in a hearing earlier this month. Most “average” investors were unable to easily and efficiently invest in commodities prior to the introduction of commodity ETFs. Since position limits restrict the ability of commodity ETFs to grow beyond a certain size, they also limit the ability of sponsors to increase revenues and realize certain economies of scale. As such, the CFTC’s actions will likely lead to limited availability and increased expenses for many retail commodity investors.

Is The Honeymoon Over?

The debate over the regulation of commodity ETFs highlights increased scrutiny on the operations of the ETF industry in recent months. Also in the spotlight recently have been leveraged ETFs, investments that provide amplified daily returns on benchmark indexes, but can generate undesirable returns when held for multiple trading sessions in certain market environments.

As use of ETFs has become more widespread, issues have arisen that have drawn the ire of investors and regulators alike, signaling that the industry is taking a closer look at exactly how these securities function and some of the issues that they may present. Although it’s impossible to tell for sure, all indications are that we are headed for more regulation in the ETF industry.

Disclosure: No positions at time of writing.