The rapid rise of the ETF industry has caused the expanded the investment arsenal of millions significantly, bringing asset classes previously reserved for only the largest and most sophisticated investors within reach. This development is perhaps best demonstrated by the surge in popularity of exchange-traded commodity products. According to data from the National Stock Exchange, commodity ETFs took in more than $30 billion in 2009, an amount that is even more remarkable considering that domestic equity funds saw outflows of over $8 billion.
In addition to broad-based products, dozens of commodity-specific funds have come to market, offering exposure to everything from gold and crude oil to cotton and coffee. One of the most popular resource specific exchange-traded products is the United States Natural Gas Fund (UNG), which is designed to track in percentage terms the movements of natural gas prices. UNG alone saw cash inflows of $5.6 billion in 2009, and has become one of the most heavily-traded securities in the world. See charts of UNG here.
Fuel Of The Future?
The wave of inflows into UNG is no doubt attributable in part to the hype surrounding natural gas a a critical components of plans designed to wean domestic consumers and industries from a dependence on foreign oil. With momentum building towards coordinated global efforts to combat climate change, clean-burning natural gas has been repeatedly held out as one of the solutions.
Despite massive new discoveries of gas reserves, many investors believe that the long-term outlook for natural gas is bright, especially given the star power and deep pockets behind campaigns to promote widespread use of the fuel. But the best strategy for playing an anticipated rise in prices in unclear.
Most investors looking to either hedge exposure or speculate on gas prices have turned to either UNG or the iPath Natural Gas ETN (GAZ) to do so. But as many of these investors learned the hard way, these products are securities that can be impacted by a number of factors beyond natural gas prices (see What’s Wrong With UNG? for a closer look at how contango impacts UNG).
For much of last year, the relationship between natural gas and UNG was almost perfect. Amidst massive new discoveries of gas reserves and a continued slide in industrial demand, natural gas prices sunk throughout the first eight months of 2009, and UNG moved almost in lock step. But once gas prices bottomed out and began to head higher, the consequences of a futures-based strategy became clear.
Because UNG primarily invests not in physical natural gas (doing so is impractical) but rather exchange-traded futures contracts, the value of the fund’s underlying assets are impacted by the rolling of near-month contracts as they approach expiration.
Frustrated by the significant gap between hypothetical returns on spot natural gas and UNG’s price, some investors have sought out ways to gain exposure that eliminate the potential “return erosion” of a futures-based strategy. Below is a look at three ETFs that many have embraced as alternatives to UNG (for more actionable ETF investment ideas, sign up to our free ETF newsletter).
First Trust ISE-Revere Natural Gas ETF (FCG)
This ETF is based on an equal-weighted index comprised of companies that derive a substantial portion of revenues from the exploration and production of natural gas. In order to be eligible for inclusion in the index underlying FCG, companies must meet a proven natural gas reserves threshold. From the universe of all companies that meet these requirements, potential index components are ranked by price-to-earnings ratio, price-to-book ratio, return on equity, and correlation to gas futures prices. While the first three metrics are typical of enhanced indexing strategies, the fourth is obviously unique, and should act to increase the correlation between this ETF and spot gas prices. The 30 stocks with the highest rankings are then eligible for inclusion (see FCG’s holdings page).
JP Morgan Alerian MLP Index ETN (AMJ)
This ETN is linked to a cap-weighted benchmark designed to reflect the performance of the energy master limited partnership (MLP) sector. MLPs are limited partnerships that trade on U.S. exchanges. The majority of MLPs operate in the energy infrastructure industry, owning assets such as pipelines that transport crude oil and natural gas. Many MLPs generate fee-based revenues that are not directly tied to changes in commodity prices, meaning that the relationship between this fund and spot prices may not always be strong. AMJ pays a variable quarterly coupon linked to the cash distributions of the partnerships that make up the index. As of mid-December, AMJ has a current yield above 6%.
Because the ETN coupons are reported on form 1099s, investors in AMJ avoid K-1′s completely, one of the drawbacks associated with UNG. See more information on AMJ’s fact sheet.
Oklahoma Exchange-Traded Fund (OOK)
The first state-specific ETF, OOK invests in companies headquartered in Oklahoma. The pool of stocks includes a number of companies engaged in various aspects of the natural gas industry, including exploration and production and pipeline management. Major weightings in OOK are given to Chesapeake Energy, Devon Energy, ONEOK, and The Williams Companies (see our interview with the man behind OOK here).
While a significant portion of OOK’s assets are allocated to the energy sector, it isn’t a pure play on energy, and also offers diversification across other sectors. OOK’s holdings include Bancfirst, Pre-Paid Legal Services, and Sonic Corp., among others. In a sense, OOK is to the energy sector what the PowerShares QQQ (QQQQ) is to technology. QQQQ has a heavy tilt towards tech firms (about 65% of holdings), but allocations to companies like Starbucks, Sears, and Urban Outfitters offer exposure to unrelated industries (see fundamentals of OOK here).
OOK is a relatively new ETF (launched in October), so evaluating its correlation with natural gas prices is a little tricky. But early indications are good: the fund has gained more than 11% since its inception in October. Another attraction to OOK: it’s significantly cheaper than both FCG and AMJ, charging expenses of just 0.20% (compared to 0.60% and 0.85%, respectively).
While the aforementioned ETFs may provide indirect exposure to natural gas prices, an investment in any of these funds comes with potential drawbacks as well. One of the primary attractions of an investment in commodities is the low correlation of natural resources to stocks and bonds. The three ETFs profiled above invest primarily in equities, meaning that prices will generally be correlated to the broader markets. Moreover, the correlation to spot natural gas prices will be far from perfect, in part because the revenues of many of the companies underlying these funds are derived from arrangements that are not impacted by current price levels. A strong automotive industry isn’t necessarily good news for the tollway operators, and a jump in natural gas prices may not boost these alternatives to UNG (see technical analysis of UNG here).
An uncertain regulatory environment hangs over UNG, and the fund’s performance relative to spot prices last year has caused many investors to think twice about natural gas investing. Fortunately for those bullish on natural gas prices but scared of UNG’s volatility and “contango dependence,” there may be more than one way to skin this cat.
Disclosure: No positions at time of writing.