Some ETFs Hit Breaking Point

NEW YORK (TheStreet) -- As investors digest news of the latest trading troubles in PowerShares DB US Dollar Index Bullish ETF(UUP Quote), they should take note of an alarming new trend in the ETF industry.

As investors flood into funds to take advantage of the latest market trends, some ETFs have reached a breaking point.

During 2009, an influx of investor interest in funds like United States Natural Gas(UNG Quote) and PowerShares DB Commodity(DBC Quote) has resulted in creation halts and strategy reconstructions. While UNG and DBC have been saved by strategy overhauls, the fate of other funds is less certain.

The Commodities Futures Trading Commission has been monitoring the impact that certain ETFs have on the commodities that they are designed to track. New position limits prompted the restructuring of funds like UNG, DBC and PowerShares DB Agriculture, and the closing of the popular PowerShares DB Crude Oil Double Long ETN(DXO Quote).

More recently, the iPath Dow Jones Platinum ETN(PGM Quote) halted creation to stay within position limits.

Another challenge to funds like UNG and UUP is the necessary SEC approval to create additional blocks of shares. As investors rush into ETFs, it triggers the creation of new shares by authorized market participants.

The process of share creation is perhaps the most defining aspect of the ETF industry. Unlike closed-end funds, ETFs are designed to closely track their underlying indexes. This is possible because of share creation and redemption.

When the creation process is interrupted, as is currently the case with UUP, ETFs cease to exist as ETFs, but rather trade at premiums to their underlying value like CEFs. Professional traders breed in these gaps, as the people with the inventory increase their vig and lock in their hedges. Increased electronic participation and volume have helped to narrow the spreads in popular ETF funds. A creation halt is great for shareholders and bad for individual investors chasing a trend.