Regulatory Body Closing UNG Loopholes
Neither snow, nor rain, nor heat, nor gloom of bilateral and unregulated OTC swap markets will stop the Commodities Futures Trading Commission from capping the impact of the United States Natural Gas ETF.
Despite a technically clever internal reorganization, the managers of UNG may once again have to face the regulators they dodged. The latest position-limit proposals from the
CFTC
could put pressure on the swaps dealers that have been the lifeblood of UNG in recent months.
After hitting up against a series of share restrictions last summer, UNG managers began to "reposition" their strategy to escape the CFTC's jurisdiction.
UNG's original strategy, and promise to investors, was to track the price of natural gas delivered at the Henry Hub, La, through the price futures contract on natural gas traded on the New York Mercantile Exchange.
Confused? Essentially, since natural gas is difficult and costly to store, UNG managers designed UNG to track futures contracts rather than going out and buying barrels of oil in Louisiana.
These futures contracts, which are a way to "own oil" without buying a warehouse, must be traded in accordance with the rules and regulations of the New York Mercantile Exchange.
Here's where the CFTC comes in.
Worried that funds like UNG would begin to impact the price of the commodities they were designed to track, the CFTC began formulating "accountability" limits. These position limits, which have been inevitable
since the summer of 2009
, keep funds like UNG from owning an inordinate supply of futures contracts.
The proposed position limits, which many of the large futures-based funds began preparing for before the new year, would essentially cap the size of UNG, forcing the fund into closed-end status when limits were reached. Funds began to come up with creative ways to operate within CFTC proposals while continuing to grow.
Position limits? No problem! Sick of regulators? Go unregulated!
UNG's managers began drawing down their stake in NYMEX futures last summer and moved into the realm of unregulated, bilateral over-the-counter swaps. As UNG's managers moved further into unregulated territory, disclosures like these began showing up on the fund's website:
"Acceptance of creation orders from APs as of (September 11) are subject to the condition that the AP arrange for a natural gas based total return swap contract between UNG and the AP, an affiliate of the AP, or a 3rd party on terms acceptable to UNG's management."
If it sounds more complicated,
it's because it is
. Instead of being limited by the number of futures contracts that the fund could own, managers began to grow UNG through murkier swap agreements.
And
grow it did
. As managers halted creation of new shares -- during the period they decided to
switch to a swap-based methodology
-- UNG had $0 in net cash flow during September 2009.
After the September announcement, quoted above, the wheels began turning again. During the month of October, UNG had a net cash flow of $308 million. By November it was $464 million. During the month of December, $219 million flowed into the fund.
Despite regulatory setbacks, UNG's massive growth speaks for itself. UNG had $705 million in assets as of December 2008. At the end of 2009, UNG's assets were $4.047 billion.
The CFTC, however, may end up having the last laugh.
After analyzing the latest proposals from the CFTC, Energy analyst Olivier Jakob from Petromatrix noted that: "Outside of bilateral swaps, the UNG is holding the equivalent only of about 36,000 contracts which would still be below the CFTC Single Month limit. However, the UNG would have to find Swap Dealers that would not be restricted themselves by limits, and since Swap Dealers that would have an exemption could be required by the CFTC to provide the list of clients and the daily activities with those clients, it could then become a risk factor for the Swap Dealers or any other entity that is fronting for a Fund that is itself subject to position limits.**"
As observed by Jakob, UNG's managers may have problems finding swap dealers to "front" their operation if the CFTC keeps a close eye on things. Even if UNG finds swap dealers that are not restricted by limits, unrestricted swap dealers could be required to provide a list of clients.
Helping to grow a fund that the CFTC has been furiously trying to reign in? May not be such a good idea. Might not look so good.
OK UNG, your move.
Note: ** Source: Financial Times Alphaville:
"Digging Deeper into the CFTC's Position."
-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion did not have any holdings in the funds mentioned.
Don Dion is president and founder of
, 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.