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TheStreet Open House

Gold ETF Buyers Must Recognize Risks

Stocks in this article: GLD IAU UNG

Surging prices, rising investor interest and the passage of the Dodd-Frank Act could leave some gold exchange-traded fund investors in a caustic regulatory crossfire in the months ahead. As the Commodities Futures Trading Commission prepares to implement provisions of the Dodd-Frank Act, it's more important than ever that ETF investors pop the hood on their funds and understand the potential risks.

To fully understand the ramge of issues that gold ETF investors could face, it's best to start with a quick discussion of the United States Natural Gas ETF (UNG) and the challenges the fund has faced during the past year.

When United States Commodity Funds LLC set out to launch UNG in 2008, the issuer sought to offer investors exposure to natural gas prices, specifically the changes in percentage terms of the price of natural gas delivered at Henry Hub, La. To reflect the price of Henry Hub natural gas, UNG's portfolio was designed to track changes in the price of the near-month futures contract on natural gas traded on the New York Mercantile Exchange. (That's except when the near-month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire, less UNG's expenses.)

To put it simply, UNG was designed to track NYMEX-traded natural gas contracts. As assets flowed into the fund, UNG managers accommodated the interest by creating additional units of shares. In order to create these shares, more and more NYMEX-traded futures contracts went towards UNG units. (To create units, authorized participants must deliver an ETF's underlying components, in appropriate amounts, to an intermediary. This intermediary delivers the components to fund issuers and the authorized participants then receive the originally requested units of shares).

As interest in natural gas and UNG soared, the fund began to attract the attention of regulators. Already concerned about the impact that the United States Oil ETF (USO) had on the market for oil futures contracts, the CFTC became concerned that UNG was beginning to influence the very contracts it was designed to track.

After a separate issue with the Securities and Exchange Commission in early 2008 (during which creation of UNG shares was suspended for registration reasons), managers of UNG self-imposed a share creation halt as they tackled the issue of growing regulatory pressure. The CFTC was gearing up to impose restrictions on the ownership of NYMEX-traded natural gas contracts, and UNG managers knew it. These position limits would cap the growth of the UNG, effectively turning the exchange-traded product into a closed-end fund (when limits were breached). This wouldn't be good for investors (creation halts cause price bubbles and disconnection between an ETF's market price and underlying net asset value) or fund managers (who would like to continue to grow the size of their fund while maintaining the fund's original objectives).

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