The U.S. Commodity Futures Trading Commission (CFTC) has been waging war against commodity index funds, and visible evidence they are winning that war has already begun to manifest itself.
On September 9, Deutsche Bank redeemed outstanding shares in its PowerShares DB Crude Oil Double Long Exchange Traded Notes (DXO), effectively liquidating the note. DXO attempted to double the monthly performance of the Deutsche Bank Liquid Commodity Index – Optimum Yield Oil Excess Return Index. At the end of August, DXO had $425 million in assets.
Faced with restrictions by commodity regulators, DXO’s managers were unable to obtain adequate exposure to crude oil for the note’s normal operation. As a result, Deutsche Bank chose to redeem the notes.
Other commodity exchange-traded products have faced similar difficulties amid an increasingly restrictive regulatory environment impacting investments that use commodity futures.
How can advisors and their clients deal with the regulatory mess affecting commodity ETFs?
No Help from Regulators
Even though it has yet to produce any credible evidence, the CFTC claims that commodity index funds and other investors taking large positions in futures contracts tied to various commodities are distorting prices. These alleged distortions are far-fetched though, because commodity prices are largely driven by supply and demand.
For example, commodity ETFs that use futures contracts generally take no physical delivery of the commodities in which they invest. Expiring futures contracts are rolled into new contracts, which does little to disrupt the supply and demand metrics of the physical commodities. How is it possible to distort commodity prices without distorting their physical supply? No one at the CFTC has answered this fundamental question. Instead, commodity regulators remain stubbornly committed to disrupting the normal operation of commodity funds.
“I believe that position limits should be consistently applied and vigorously enforced,” CFTC Chairman Gary Gensler said. “Position limits promote market integrity by guarding against concentrated positions.”
By now, one would think the CFTC would actually come out and distinguish the difference between a legitimate commodity investor versus an illegitimate commodity speculator, besides its flawed attempt to set arbitrary limits on futures positions. Instead of protecting the integrity of commodities markets, regulators seem to be trying to appease politicians and the public. Blaming commodity investors for distorting commodity prices is a convenient alibi.
Commodity Funds Scramble
In response to the CFTC’s contention that commodity index funds are distorting the price of commodity futures, fund managers have been scrambling to comply with the agency’s guidelines.
Deutsche Bank expanded the number of commodities tracked by two of its commodity ETFs.
The PowerShares DB Commodity Index Tracking Fund (DBC) and the PowerShares DB Agriculture Fund (DBA) now contain additional commodities among their respective holdings to comply with position limits mandated by the CFTC.
In addition to the six commodities it already tracked, DBC added Brent crude, copper grade A, natural gas, RBOB gasoline, silver, soybeans, sugar and zinc.
DBA formerly tracked just four commodities, but added cocoa, coffee, cotton, feeder cattle, Kansas wheat, lean hog and live cattle.
Other embattled commodity ETFs and ETNs have been forced to make dramatic changes.
In late August, Barclays Global Investors temporarily suspended the creation of new shares for its $1.7 billion iShares S&P GSCI Commodity-Indexed Trust (GSG). GSG’s performance is linked to the S&P GSCI Total Return Index, which consists of a diversified group of 24 different commodities. Like other commodity ETFs and ETNs of its sort, it uses commodity futures contracts to obtain its market exposure.
Other single-commodity ETFs with large positions in commodity futures have curtailed share issuance or are now evaluating commodity exposure alternatives.
Your Commodity Strategy
If your portfolio contains a commodity fund or note that’s been impacted by changing commodity rules, your client’s investment may begin to trade at a premium to its underlying net asset value. The premiums for diversified commodity ETFs such as DBC and GSG range from 0.25 to 3.50 percent and have not gone completely haywire compared to single-commodity funds like the U.S. Natural Gas Fund (UNG), which trades at a 16 percent premium.
In this kind of environment, it’s advisable to check the premium/discount information on commodity ETFs/ETNs before investing. These data are readily obtained at the provider or sponsor’s Web site.
Avoid commodity products with dramatic premiums/discounts of more than 3 percent because they don’t reflect the true value of the underlying assets. Remember: Unlike closed-end funds, one of the chief objectives of ETFs/ETNs in the first place is to accurately reflect the value of their assets. You should question the value of commodity products that can’t consistently deliver on this most basic goal.
Avoid Problem Products
Recent problems with the natural gas fund UNG highlight the uncertain nature of U.S. commodities regulation.
Surging investment demand for UNG was so great, the fund’s general partner (because of poor planning and lack of foresight) ran out of shares to issue. An appeal to the SEC yielded a belated approval for an increase in creation units, but thus far no action has been taken by UNG’s manager.
Particularly worrisome is that UNG hasn’t been fulfilling its principal investment goal of following the price of natural gas. The August 17 Wall Street Journal correctly observed that UNG fell 75 percent in value while Nymex front-month natural gas prices were down just 50 percent. Put another way, UNG isn’t doing what it was designed to do.