A Murky Future for Commodities ETFs

10/13/2009 11:00 am EST

Focus: ETFS

Vaughn Scully of Standard & Poor’s discusses the problems that have emerged for commodities ETFs and offers two alternatives for investors who want exposure to the sector if regulators clamp down.

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.

State Street’s SPDR Gold Trust (NYSEArca: GLD) amassed a staggering $32 billion in assets, making it the fifth-largest ETF by market capitalization. [But] while GLD has so far managed to simply sock away more gold bars at HSBC’s London vault, other ETFs are now being forced to confront the vexing problem of having more demand for their shares than commodities to invest in.

Earlier this year the spectacular rise in assets held by two commodity ETFs—the United States Oil Fund (NYSEArca: USO) and the United States Natural Gas Fund (NYSEArca: UNG)—raised alarms with regulators, who fear their presence is causing price distortions.

Assets for USO peaked in March at about $3.8 billion, enough to control about 20% of the front-month crude oil contracts outstanding on the Nymex. Assets in UNG 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 and exhausting the supply of shares registered with the Securities and Exchange Commission (SEC).

While the SEC 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.”

Two other funds—iShares S&P GSCI Commodity-Indexed Trust (NYSEArca: GSG) and iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN (NYSEArca: GAZ)—said they, too, will stop issuing new shares, at least temporarily, to avoid problems with position limits.

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. Such a large presence in one market can create price distortions.

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 the premium would have to ease, whether natural gas prices go up or down. Even so, investors appear willing to take that risk in hopes of profiting from an expected rise in natural gas prices in 2010.

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 (NYSEArca: XLE)—and the materials sector—tracked by the Select Sector SPDR-Materials ETF (NYSEArca: XLB).

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