Natural Gas ETF Has Its Drawbacks

Editor's note: Don Dion is the president and chief investment officer of Dion Money Management and the publisher of the Fidelity Independent Adviser family of newsletters. He provides commentary on exchange-traded funds and mutual funds.

The United States Natural Gas (UNG Quote) exchange-traded fund has ballooned in recent weeks and has now hit a threshold where the problems inherent in the fund and the limitations on the natural gas market raise concerns for investors and regulators alike.

The most recent move on the part of the fund's managers has been to cut back futures holdings in what may be an effort to keep the net asset value of the fund in line. As ETF investors jump to get on the natural gas bandwagon, they should consider the drawbacks to UNG and available alternative investments.

1. Construction

UNG invests in front-month natural gas futures contracts that trade on the New York Mercantile Exchange. The value of the contracts is tied to the spot prices for natural gas delivered at Henry Hub, La. Natural gas is difficult to transport, so futures provide a good trading environment for investors unable to own the commodity directly. As the calendar catches up with the contracts, investors are forced to "roll forward" their investments into a later date, so UNG rolls its current contracts into the next month's contracts on a regular basis.

For example, if you own $1 billion worth of July contracts today, theoretically, you stand prepared to take delivery of the equivalent amount of natural gas in July. Imagine the reality of the situation: No one actually expects to have a tractor trailer full of natural gas show up in his driveway when the contracts expire, so he "rolls" the investments forward into the next month, and so on, as long as he desires to track the price of natural gas. UNG does this for its investors as part of its methodology.