UNG vs. FCG: A Better Natural Gas ETF?

by on April 26, 2010 | ETFs Mentioned:

One of the hottest segments of the ETF industry is the commodity space, which has exploded in recent years as investors have embraced exchange-traded products as a means of reaching an asset class that offers potentially valuable diversification benefits. While most commodity products are physically-backed or futures-based funds, an alternative means of gaining commodity exposure has become increasingly popular among ETF investors. A number of equity ETFs focusing on stocks of companies engaged in the production or extraction of hard assets have popped up and received a very warm reception from the market.

This concept is nothing new–investors have been making bets on changes in oil prices through stocks in the energy sector for ages–but the expansion to nearly every corner of the commodities market is a relatively recent development. The Market Vectors Gold Miners ETF (GDX) is the largest ETF in the Commodity Producers Equities ETFdb Category with assets of  more than $5 billion, and several smaller funds offer exposure to everything from agribusiness (MOO) and copper (COPX) to steel (PSTL) and timber (CUT).

While the correlation to the spot price of the underlying resource is often diminished–these funds are, after all, equities–they offer certain advantages as well. Stocks aren’t subject to erosion of returns stemming from contangoed futures markets (see How Contango Impacts ETFs), and potentially offer more favorable tax treatment than certain physically-backed ETFs.

Few commodities have been the subject of more discussion among investors than natural gas over the last two years. As prices have plummeted and pushes to adopt clean energy alternatives have gained traction, many have identified natural gas as a commodity that could see a tremendous surge in prices. One of the most popular ways to gain exposure to natural gas prices has been through the United States Natural Gas Fund (UNG), which invests in near month natural gas futures contracts. UNG took in more than $5 billion in cash in 2009, at one point accounting for a substantial portion of open interest in NYMEX contracts (see Six Reasons UNG Is Due For A Comeback).

FCG: Playing Natural Gas Through Equities

Not every investor looking to play natural gas through ETFs has gravitated towards UNG. The First Trust ISE-Revere Natural Gas Index Fund (FCG) now has assets of nearly $500 million, reflecting its increasing popularity as perhaps a more efficient way of betting on natural gas prices. FCG tracks the performance of the ISE-Revere Natural Gas Index, an equal-weighted benchmark comprised of companies that derive a substantial portion of their revenues from the exploration and production of natural gas.

In order to understand why FCG might exhibit a strong correlation with spot natural gas prices, it’s important to take a look at the methodology behind this index. After identifying all companies involved in exploration and production of natural as, stocks whose natural gas proved reserves don’t meet certain requirements are removed. Those remaining are ranked using four different metrics: price/earnings ratio, price/book ratio, return on equity, and correlation to gas futures prices. The 30 stocks with the highest average rankings are included in the index, resulting in a group that includes the likes of Mariner Energy, Pioneer Natural Resources Company, and Noble Energy (see the FCG fact sheet).

So conceptually, the reasons for a relatively strong relationship between gas prices and FCG’s price are clear; component companies must have a certain level of proved reserves and exhibit a correlation with futures prices.

But how well does this translate to actual returns? Since its inception nearly three years ago, FCG has exhibited a correlation of nearly 0.90 with near month natural gas futures prices, slightly less than the coefficient between UNG and futures prices. But in terms of total returns, FCG has whipped both UNG and the change in futures prices. Over that period FCG is down about 5%, while futures prices have slipped by about 50% and UNG has astonishingly lost more than 85% of its value.

OOK: Another Interesting Alternative

For investors looking to gain exposure to natural gas, there’s another interesting ETF out there that might be worth closer look. The Oklahoma Exchange-Traded Fund (OOK) tracks the performance of the SPADE Oklahoma Index, a benchmark that measures the performance of publicly-traded companies whose corporate headquarters are located in the state of Oklahoma. While OOK doesn’t explicitly target natural gas companies, the composition of Oklahoma’s economy gives this fund a heavy tilt towards the energy sector (think of OOK like the Nasdaq, replacing tech companies with the energy sector).

Among OOK’s largest holdings are Williams Companies (a Tulsa-based natural gas exploration firm), ONEOK Partners (a major natural gas distributor), and Devon Energy (the larges U.S.-based natural gas and oil producer). And there are a  handful of pipeline operators, exploration and production companies, and distributors among the remainder of the 30 or so holdings. OOK is a relatively new ETF–it launched in late 2009–so it’s tough to evaluate its historical performance relative to natural gas prices. And the inclusion of stocks like Dollar Thrifty, Sonic Corp, and Southwest Bank will certainly weaken the relationship. But it’s certainly an interesting ETF to consider when looking for ways to play natural gas (see Why OOK Is Crushing XLE).

The Verdict

Declaring one ETF as universally superior to its peers is, if not impossible, irresponsible; the most appropriate ETF option will depend on goals of each investor. For those looking to make a play on natural gas, there are a few different options, including futures-based products and “indirect” exposure through equities.

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Disclosure: No positions at time of writing.