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ETF Regulation Battle Bad for Investors

Stocks in this article: USO

NEW YORK ( TheStreet) -- Commodities ETFs continue to steel themselves against an approaching army of regulators.

iShares S&P GSCI Commodity Indexed Trust (GSG) has followed the example of United States Natural Gas (UNG) and halted share-creation. As issuers and regulators prepare to clash, it is a third party, the individual investor, who stands to lose the most.

ETFs have offered unprecedented access to the commodities markets through the use of derivatives such as futures contracts and swaps. Where once only institutions could invest, individuals have gained access to "pure" commodities vehicles.

Top Commodity Play

Investors rushed in, and funds like United States Oil (USO) and UNG became bloated with assets.

Regulators such as the Commodities Futures Trading Commission believe that these futures-based commodity ETFs have become too big for their britches and are looking to curb the funds with position limits.

The PowerShares DB Commodity Index Tracking Fund (DBC) and the PowerShares DB Agriculture Fund (DBA) have already been subject to changing regulation. On Aug. 20, the CFTC repealed an exemption that previously exempted these funds from position limits.

By limiting the number of futures contracts that a fund like UNG can own, regulators essentially give these fund issuers two choices.

The first and increasingly most popular option is to halt creation. If a fund can't buy more futures and grow, it can simply stop issuing new shares. Creation of UNG was halted by force in July and extended by choice in August. UNG's managers simply decided not to risk running in the path of a regulatory freight train.

GSG, the most recent fund to follow in UNG's footsteps, joins the iPath Dow-Jones-AIG Natural Gas ETN (GAZ) and the PowerShares DB Crude Oil Double Long ETN (DXO) in halting share-creation.

The second choice, most likely to be used in conjunction with the first, is for ETF managers to come up with another strategy. Funds like UNG and GSG use futures contracts to achieve their investment objectives. If they can't use futures, they can find something else.

UNG is already combining the first choice with the second and is selling futures contracts and buying swaps. These swaps are not regulated in the same way as futures contracts. Other products like GSG will likely be forced to follow suit if position limits on futures are put in place.

Neither one of these options, halted creation or on-the-fly restructuring, is good for investors. Creation plays a defining role in the ETF process. It is through the creation and redemption processes that ETFs actually track their underlying indices. A disruption in either one of these steps will cause a disconnect between the price of the fund and what it is worth.

Investors will suffer by paying huge premiums to buy shares of funds like UNG and GSG.

The implicit promise made to each ETF investor by the ETF industry is that the shares of a fund will track an underlying index. Halting creation means breaking this promise.

The consequences of on-the-fly restructuring could be even greater. Other derivatives markets make commodities futures look tame, and alternative strategies like swaps could put individual investors at even greater risk.

If regulators are truly worried about investors getting hurt by derivatives, they should consider the alternatives that these funds will use to achieve their objectives.

GSG may be the latest fund to protect itself from regulation, but it won't be the last. ETF issuers have been alerted by regulators that the rules could be changed mid-game. When the music stops, it is investors who will be left standing.

-- Written by Don Dion in Williamstown, Mass.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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