ETF Expert

Eric Fox at Investopedia expressed several valid concerns regarding commodity ETFs. Specifically, with the Commodity Futures Trading Commission (CFTC) agreeing to hold July/August hearings on energy futures speculation, how might new restrictions affect commodity linked ETFs?

Keep in mind, the vast majority of U.S. based commodity ETFs do not hold the specific resource, metal, material or agricultural product. Many people have asked why this is, but when you think about it, there's not too many banks set up as storage centers for jillions of gallons of crude oil or natural gas. That's why many ETFs purchase futures contracts, looking to approximate the return of an underlying commodity (e.g., nat gas, crude oil, etc.) or a basket of commodities (e.g., precious metals, base metals, agriculture, etc.).

Using ETFs that depend on futures prices for single commodities or commodity baskets has led to a number of troubles. For instance, the most popular crude oil vehicle, United States Oil (USO), has had a horrendous time tracking "spot" crude prices accurately. (Note: For more details on "contango" and USO tracking woes, here's a straightforward feature on this ETF's problems.)

ETF providers wish that the only issue that they face had to do with futures contracts. Demand for shares of United States Natural Gas (UNG) recently exceeded the SEC-approved number of creation units. When this has happened with ETFs in the past, the provider simply registered more units with the SEC, and received rapid approval. But not this time!

Today, the Obama Administration is keenly aware of the perception that energy speculators caused the irrational rise and devastating collapse of the oil/gas bubble. So the SEC may, in fact, choose to limit perceived speculation by not approving the request for additional UNG units.

As it currently stands, UNG is trading at a premium to its net asset value, much like a closed-end fund. Remember, one of the differences between an open-end ETF and a CEF is the ETF's ability to trade very close to net asset value. CEFs can trade at 20% discounts and 20% premiums… making some index investors crazy.

While the CFTC is planning to focus its attention primarily on oil and gas… many metals and agricultural ETFs also use futures contracts. While new regulation could reduce extreme swings that are due in part to speculation, it may also inhibit commodity ETF ability to track indexes (already an issue) or even stay close to underlying asset value (a la the problem with Unites States Natural Gas).

One of the answers that Barclays introduced with its iPath products were exchange-traded notes. They pretty much track the indexes because they are contracts with the bank for you to get the annual index minus the company's costs/expenses/profit margin. In fact, I used to advocate using the iPath Dow Jones Total Commodity Index (DJP) for total commodity exposure… as long as investors minded their stop-losses.

Unfortunately, exchange-traded notes (ETNs) present credit risk. And these days… with the financial crisis still rattling a sabre… that's more risk than many are willing to take.

Bottom line? There's no easy answer to to the commodity ETF/ETN conundrum. The uncertainty over new regulations may cause buyers to sit on the sidelines; conversely, the certainty of the new rules may open the door for informed decision-makers on which ETF to use.

If you'd like to learn more about ETF investing… then tune into "In the Money With Gary Gordon." You can listen to the show "LIVE", via podcast or on your iPod.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.