Commodity ETFs prepare for looming regulation

Funds tracking agricultural, natural gas and other futures are taking steps to protect themselves.

By TheStreet Staff Sep 20, 2011 11:21AM

Image: Farmhouse (© Mark Karrass/Corbis)By Don Dion, TheStreetTheStreet

 

Over the weekend, The Economist noted that the Commodities Futures Trading Committee is taking aim at speculators by proposing to implement position limits on contracts for 28 separate commodities.

 

The report says the CFTC's goal is to bar any individual from controlling more than a quarter of the total U.S. supply of any of these commodities.

 

In recent years, investors have learned firsthand that heightened regulation can affect the inner workings of a futures-tracking ETF. Perhaps the most glaring example is the United States Natural Gas Fund (UNG).

 

UNG is designed to be used as a tool for investors looking to gain exposure to natural gas. In order to reflect this commodity's price changes, the fund tracks a basket of futures contracts.

 

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With the fund's wild popularity came challenges. As UNG ballooned during the latter half of 2009 and start of 2010, the fund was forced to buy up more futures contracts until it eventually grew unsettlingly close to the limits set by the CFTC. In the event that these limits were breached, the fund would be forced to halt share creation, resulting in the generation of a premium.

 

To skirt this risk and protect its product, the fund's manager opted to take a unique and controversial action: The fund expanded its reach beyond futures contracts and into swaps. Swaps continue to represent a large percentage of UNG's underlying holdings.

 

UNG is not the only fund that has had to make changes in the face of increased regulation. Other products are also taking preemptive steps to defend against looming regulatory action.

 

The PowerShares DB Agriculture Fund (DBA) and PowerShares DB Commodity Fund (DBC) both witnessed dramatic restructurings. Today DBA provides investors with exposure to 11 individual agricultural commodities compared with five different crops in late 2009. The pool of commodities tracked by DBC, meanwhile, has more than doubled in order to avoid running into the limits set by regulators.

 

In the near term I would encourage investors to use caution when venturing into futures-backed ETFs. Well-diversified products like DBA and DBC appear properly suited to handle increased oversight from the CFTC. Single-commodity products like UNG, however, may stand a greater risk of feeling pressure from the regulatory body's decisions. Ultimately, until more information is learned, patience, level-headedness, and flexibility will be crucial to navigating the marketplace.

 

With the CFTC again mulling the idea of tightening its grip on the futures market, the waters may soon become muddied for the wide pool of futures-backed exchange traded funds. There appear to be places that investors can turn to in order to maintain exposure to commodities and avoid the threat of interference on the part of the CFTC, however.

The Economist article goes on to note that physical commodities appear safe from the threat of increased regulatory oversight. Investors using funds like iShares Gold Trust (IAU) or ETFS Physical Palladium Shares (PALL) should not have to worry at this time.

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