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Funds Flow Into Closed Natural Gas ETF

The halt in creation of shares has made UNG trade more like a closed-end fund.
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WILLIAMSTOWN, MASS. (TheStreet) -- U.S. Natural Gas (UNG) - Get United States Natural Gas Fund LP Report had the highest asset inflows of any ETF during the month of July, according to data published by Morningstar (MORN) - Get Morningstar, Inc. Report. UNG, which tracks a basket of futures and swaps to capture the price of natural gas, had an inflow of more than $1 billion, besting funds like PowerShares QQQ (QQQQ) and SPDRs S&P 500 (SPY) - Get SPDR S&P 500 ETF Trust Report.

This information will come somewhat as a surprise to investors who have been following the drama behind the scenes at UNG. On July 7 UNG was forced to halt creation of additional shares when the pre-approved number was exhausted. UNG initially lobbied to create 1 billion additional units to satisfy growing demand.

The creation process serves two important roles for ETFs. First it allows funds to grow. Through the issuance of new shares, usually 50,000 or 100,000 units, allows for an increase in assets under management and gives investors access to the fund. Second, and perhaps most important, the creation/redemption process keeps the market price of ETFs close to their net asset values.

Since market makers have the ability to

completely hedge ETF positions

, the creation of units to meet demand keeps the funds in line with their objectives. Market makers can simply sell the ETF, buy back the underlying stock and create more shares when necessary.

The creation process is what separates ETFs from other funds. Halting creation in UNG suddenly causes a problem for market makers who have to hedge their exposure. If you cannot readily both buy and sell shares of UNG, it takes away the motivation to keep a tight, two-sided market.

Cutting off creation turns an ETF into something that resembles a closed-end fund. Closed-end funds regularly trade at premiums or discounts to underlying value, an issue many investors are attempting to avoid when buying ETFs. During the month of July, UNG regularly traded at a premium to its underlying value or NAV. If the creation/redemption process is designed to keep a fund in line with its NAV, the absence of it will inevitably cause things to go out of whack.

While the halt in creation certainly explains the price disconnect, the inflow of assets is a bit murkier. If UNG halted creation of new shares on July 7, how did the fund have such an incredible influx of assets?

A representative from UNG spoke to me about the influx phenomenon. Since settlement on creation units does not happen instantaneously, funds continued to flow in after creation was halted. So while UNG did not issue any more shares after July 7, the assets necessary for those creations flowed in over a longer period.

The Commodities Futures Trading Commission (CFTC) has recently been holding hearings to discuss position limits for the type of futures that make up funds like UNG and

U.S. Oil

(USO) - Get United States Oil Fund LP Report

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. A restriction on the number of contracts that UNG managers are able to buy would also

dramatically affect creation and pricing

.

UNG's response to upcoming regulation has been to restructure the fund. During July, UNG managers began selling the potentially-regulated futures contracts and buying other investment vehicles like swaps. A dramatic change in the construction of the fund will change what the fund "tracks" and should be understood by investors who are considering purchasing the fund.

UNG's portfolio, previously subject to the regulations of the New York Mercantile Exchange will now expand beyond that reach into OTC territory.

As the portfolio shifts from futures to swaps

, a host of new questions about liquidity and regulation will beset the fund.

UNG is in the middle of an overhaul and will not go down without a fight. Investors should stay away from UNG until the dust settles, as the very essence of the fund is changing. Already boasting a sophisticated strategy for seasoned investors, UNG is about to become more complex.

-- written by Don Dion in Williamstown, Mass.

At the time of publication, Dion was long QQQQ.

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.