From the October 2009 issue of Research Magazine • Subscribe!

Natural Gas ETF Hits a Wall

Commodity regulators have been looking for ways to restrict the trading in futures contracts by commodity pools like the U.S. Natural Gas Fund, UNG.

Exchange-traded funds touted as a convenient way to obtain market exposure have now become an inconvenient headache.

At the center of the chaos is the U.S. Natural Gas Fund (UNG), which is supposed to follow the price of natural gas. Surging investor demand for UNG forced the fund's general partner to run out of shares. A dramatic public appeal to the SEC yielded a belated approval for an increase in creation units, but what UNG's partners will do next remains to be seen.

Unfortunately, poor planning compounded by a lack of foresight has contributed to UNG's woes. Instead of trading like an ETF with minimal discrepancies between share price and net asset value, UNG trades more like a closed-end fund, with noticeable premiums and discounts.

Even more bothersome is that UNG hasn't been fulfilling its prospectus-described investment goal of following the price of natural gas. The August 17 edition of the Wall Street Journal correctly observed that UNG has fallen 75 percent in value while Nymex front-month natural gas prices were down around 50 percent over the same period.

Commodity regulators have been looking for ways to restrict the trading in futures contracts by commodity pools like UNG. While they have yet to produce any meaningful research to support their case, regulators insist that commodity prices are being needlessly distorted by trading from commodity pools.

For advisors that want accurate exposure to natural gas, they best look elsewhere.

Contango vs. Backwardation

Commodity ETFs like UNG that invest in commodity futures rather than physical commodities must roll their futures positions every month into new contracts as the old contracts expire. If future commodity contracts are more expensive than spot prices, this creates a situation known as "contango." With contango, the commodity fund's performance is likely to produce negative returns, as it replaces expiring contracts with higher priced contracts. Contango is a contributing factor in explaining why UNG has performed worse than its benchmark.

When spot commodity prices are more expensive than future prices, the opposite of contango occurs. This situation is known as "backwardation." Steep backwardation often indicates the marketplace perception that an immediate shortage of a particular commodity is at hand.

Finding Alternatives

Another way to obtain market exposure to commodities is by owning equity ETFs that follow commodity-related industry sectors. Examples of commodity sectors include agriculture (PAGG), basic materials (XLB), energy (VDE), mining companies (GDX), timber (CUT) and oil and gas producers (XOP).

If your clients are keen on commodities but not sure which ones, take a look at diversified commodity ETFs that invest in a broad basket of various commodities.

To date, commodity ETFs like the iShares S&P GSCI Commodity Indexed Trust (GSG), GreenHaven Continuous Commodity Index Fund (GCC) and the PowerShares DB Commodity Index Tracking Fund (DBC) have avoided operational issues facing other commodity funds.

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