October 6, 2009

Are Some Commodity ETFs Victims of their own Success?

Among the success stories to emerge since exchange-traded funds (ETFs) made their debut in 1993, few have been more remarkable than the extraordinary growth of commodity ETFs--funds that offer direct exposure to items such as crude oil, copper, and corn. No fewer than 60 of the 800-odd ETFs listed on U.S. exchanges are tied to movements in individual commodities, groups of related commodities, or broad-based commodity price indexes. The undisputed leader of them all is State Street's SPDR Gold Trust (GLD), which has amassed a staggering $32 billion in assets, making it the fifth largest ETF by market capitalization.

Yet, that kind of success breeds problems of its own, problems that ETF issuers and investors are only now starting to confront and comprehend. While the SPDR Gold Trust has so far managed to escape growing pains associated with such dramatic expansion by simply socking away more gold bars at HSBC's London vault, other ETFs have not been so lucky, and are now being forced to confront the vexing problem of having more demand for their shares than commodities to invest in.

The problem came to light earlier this year as the spectacular rise in assets held by two commodity ETFs--first the United States Oil Fund (USO) and more recently the United States Natural Gas Fund (UNG)--raised alarms with regulators who fear they are too large for the markets they invest in, and their presence is causing price distortions. While each fund was set up to track the front-month futures contract for crude oil or natural gas as traded on the New York Mercantile Exchange (NYMEX), both funds have been forced to shift assets into other markets, such as London's Intercontinental Exchange (ICE), to accommodate new investment.

Assets for the United States Oil ETF peaked in March at about $3.8 billion, six times its size a year earlier and enough to control about 20% of the front month crude oil contracts outstanding on the NYMEX. (The ETF's assets have declined to a slightly more manageable $2.3 billion at the end of June.) Assets in the U.S. Natural Gas ETF, which buys the smaller, more volatile natural gas contract, ballooned from $700 million at the start of 2009 to almost $4 billion by July--enough to control 86% of the active month natural gas contracts, according to a Bloomberg report, and exhausting the supply of shares registered with the Securities and Exchange Commission (SEC). Mysteriously, the growth assets came as prices for both commodities have plunged.

As demand for UNG shares kept growing--it had the largest cash inflow of any ETF during July--a premium in the share price above the fund's net asset value developed; it topped 18% in early September. With energy consumers starting to complain about the growing influence of these and other ETFs in energy futures markets, the Commodity Futures Trading Commission held a set of hearings in July to discuss whether to impose position limits on speculators trading energy contracts as it does for agricultural futures.

While the SEC has approved plans by UNG to sell one billion new shares--enough to raise $12 billion and triple the size of the fund--the fund filed a notice in August saying it will not issue the shares on concern that it "could not invest the proceeds... due to current and anticipated new regulatory restrictions and limitations."

In the wake of UNG's announcement, two other funds (GSG) and Sub-Index ETN (GAZ)--said that they too will stop issuing new shares, at least temporarily, so as to avoid problems with position limits. Deutsche Bank decided to close the PowerShares DB Crude Oil Double Long ETN (DXO).

The standoff that emerged exposes several problems that commodity ETFs must confront. By giving the average investor easy access to commodity futures, commodity ETFs are tapping into a source of funds so large that it can upset the existing balance between buyers and sellers with its massive resources. Such a large presence in one market can create price distortions and undermine confidence in the market generally.

ETFs that own commodity futures also suffer from a mismatch between the open-end nature of the fund and the fact that futures contracts are constantly expiring, forcing the fund to "roll" its position from the expiring month into the newly active contract. This creates two problems: since the roll date is public information, traders can take positions in advance of the roll, knowing that a flood of sell or buy orders is coming into a particular contract on a particular day. It also can cause the funds' performance to decline if the expiring contract is priced below the newly active month, forcing the fund to sell the commodity at a lower price than it can buy for in the following month, a phenomenon known as "negative roll yield."

Furthermore, by allowing a price premium to develop and persist, ETF issuers risk losing the investor confidence they have painstakingly have built up over the past 15 years. The "Create/Redeem" feature, in which institutional investors add or subtract shares according to market demand, has been a highly effective tool to prevent the appearance of premiums or discounts that halted the growth of closed-end mutual funds. (Closed end funds now hold just $200 billion in assets, compared with $640 billion for ETFs and $10 trillion for open end mutual funds).

For now, the 18% premium in the UNG share price over its net asset value should be worrying to investors; not only has it persisted, but even widened over time. How long it will last is anyone's guess, but at some point, it would only seem logical that the premium would have to ease whether natural gas prices go up or down. Even so, investors appear to be willing to take that risk in hopes of profiting from an expected rise in natural gas prices in 2010. Using data from IHS Global Insight, Standard & Poor's forecasts that natural gas prices will average about $3.84 per million British Thermal Units in 2010, 36% above their price at the end of August, and $6.39 per million BTU in 2011. Whether the fund can actually capture that rise remains to be seen.

Standard & Poor's Chief Investment Strategist Sam Stovall thinks a less-risky approach would be to invest in the two sectors that most consistently track commodity prices. S&P Equity Strategy advises overweighting the energy sector--tracked by the Select Sector SPDR-Energy ETF (XLE), and the materials sector--tracked by the Select Sector SPDR-Materials ETF (XLB). (Charts on the asset flows and volumes of both of those Select Sector SPDRs are graphed exclusively on WealthManagerWeb in the Advanced Investing Strategies area.)

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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