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
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
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).
UNG managers came up with a plan: If position limits were going to be placed on NYMEX-traded futures contracts, fund managers would simply alter the fund's creation process to bypass the new restrictions. Instead of requiring the delivery of NYMEX-traded natural gas contracts for new UNG share units, UNG managers began to request the delivery of bilateral swaps. Since bilateral swaps are traded over the counter, their use in UNG share creation would not be subject to CFTC limitations on NYMEX futures trading.
Regulators caught on. The CFTC last January submitted a proposal to establish federal speculative position limits for futures and option contracts on certain energy products. UNG and USO were both discussed in the rule proposal, and it became clear that the CFTC was ready to take steps to monitor "certain energy products" in a broader sense, meaning beyond the NYMEX.
Since January, however, things have changed dramatically, and the CFTC has withdrawn its January proposal. The Dodd-Frank Wall Street Reform and Consumer Protection Act contained significant revisions to the Commodity Exchange Act, which encompassed the January proposals and much more. Because of new changes, the CFTC plans to issue a notice of rule-making and propose position limits for exempt and agricultural commodity derivatives, including energy derivatives, in compliance with the CEA as amended by the Dodd-Frank Act.
Put simply, new regulations will allow the CFTC to impact the size of a large range of futures-based products beyond UNG and USO. Bilateral and other over-the-counter derivatives aren't going to cut it as an alternative anymore: The CFTC has new abilities to regulate all of these commodity derivatives, many of which will be moved onto exchanges.
This brings us back to the issue of gold ETFs, along with the issue of all futures-based commodity ETFs. Since new regulations will allow the CFTC to impose position limits on commodities futures trading, futures-based commodity ETFs -- including futures-based gold ETFs like the
PowerShares DB Gold Fund
-- could come under pressure. If these futures-based funds continue to grow in popularity, they could run into the same restrictions previously faced by funds like UNG and USO.
Gold ETF investors looking to avoid funds that could potentially be impacted by new CFTC regulations should stick with physically backed and equity-backed gold ETFs, which do not rely on futures contracts for share creation. Physically backed gold ETFs include
SPDR Gold Shares
iShares Comex Gold
ETFS Physical Swiss Gold Shares
, Equity-backed ETFs include
Market Vectors Gold Miners
Market Vectors Junior Gold Miners
Keep an eye on CFTC rule changes and be sure to understand which type of gold ETF you are considering.
At the time of publication, Dion Money Management owned IAU and GDX.
Carolyn Dion is an analyst and associate editor for the Fidelity Independent Adviser family of newsletters, Dion Money Management?s affiliate newsletter company. A former ETF specialist and NYSEArca lead market maker, Dion provides analysis on the exchange-traded product industry.
In addition to her role as analyst and editor, Carolyn is vice president of Dion Money Management, a fee-based investment advisory firm, where she assists in the development of ETF strategies. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages more than $530 million in assets for clients in 49 states and 11 countries.