When regulatory agencies put limits on trading securities that ETFs track, the entire pricing mechanism is thrown for a loop.

Proposed regulations affecting futures-based commodity and leveraged ETFs could change the industry, and

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

has been the first to speak out.

"Consumers need hedging. Producers need hedging. And you need financial intermediaries to help do that," Goldman's Chief Financial Official David Viniar noted on the recent earnings conference call.

While regulations may not be imminent for the markets as a whole, ETF investors should understand the ways in which regulatory action has already affected ETF trading.

Every ETF has an underlying net asset value (NAV) that the fund is supposed to track. The process of ETF creation helps keep share price in line with NAV during the trading day. ETF market makers create units of shares, usually in 50,000 or 100,000 share lots, to meet customer demand for funds. When investors buy shares from a designated market maker (a sort of ETF specialist), the market maker will in turn hedge his or her position to minimize risk.

How Creation and Hedging Work

As a basic example, imagine an ETF made up of just


(T) - Get AT&T Inc. Report



(VZ) - Get Verizon Communications Inc. Report



(S) - Get SENTINELONE, INC. Report

. Let's call it the U.S. Cell Phone Fund (UCF).

For the sake of simplicity, this fund will have a 50,000 share unit. On day one of trading, you create 50,000 shares. To create these shares, you have to deliver to an intermediary bank) the shares required plus any additional cash or cash equivalents. In essence, you get 50,000 shares of the fund in return for everything that is in the underlying basket.

If UCF contains 50% AT&T, 30% Verizon and 20% Sprint, you will have to deliver 25,000 shares of AT&T, 15,000 shares of Verizon and 10,000 shares of Sprint to get one unit of UCF. Before trading on the first day, you will be 100% hedged. As a designated market maker, as soon as trading begins you will have to be willing to both buy and sell the ETF during the course of the trading day.

Let's say that UCF immediately is a hit. Right after the opening on day one of trading, an order comes in for 5,000 shares. Instead of selling it to the buyer at NAV, you sell it 2 cents above. Why is this fair? Because until you can re-hedge, you are no longer 100% hedged like you were before trading.

Buying back the equivalent number of shares that you sold will take some amount of time. The 2 cents compensates you for the risk of being synthetically short 5,000 shares of UCF. To be 100% hedged again, you will then go out and buy 250 shares of AT&T, 150 shares of Verizon and 100 shares of Sprint.

If you end up buying back all three stocks when the ETF's NAV is trading 3 cents lower, you have now created a 5-cent spread. Your total profit on this trade will be $250 on 5,000 shares and you will be 100% hedged once again.

Doesn't sound like much? The average daily trading volume for the

Financial Select SPDR ETF

(XLF) - Get Financial Select Sector SPDR Fund Report

is nearly 165 million shares. The more liquid an ETF is, the narrower the spread will be. Your profit will be dependent on the spread and the volume.

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What happens if you sell all 50,000 shares of the ETF you created and customers still want more? Since you are a designated market maker with a bona fide hedging exemption, you can continue to sell shares of the ETF, effectively going short. Your overall position, however, will not be short if you are fully hedged by buying the underlying components.

There is a time limit, however, on how long you can be "short." Regulation SHO (Reg SHO) requires that after 13 consecutive days you must close out the short position. If the demand for USF is big and you sell 100,000 shares on the first day, fully hedging by buying the securities, you will end up "short" 50,000 shares of UCF and long 25,000 shares of AT&T, 15,000 shares of Verizon and 10,000 shares of Sprint.

How do you close out this position? Simply deliver the shares and create a new unit.

While this example simplifies the process, it serves to illustrate why hedging exemptions are important. If designated market makers did not stand ready to buy and sell ETFs, the funds could trade far from their NAVs, resulting in premiums or discounts.

This brings us to the proposed CFTC regulations and recent comments from Goldman Sachs on the topic of hedging. ETFs allow investors to access strategies that they could not achieve on their own. When regulatory agencies put limits on trading the securities that ETFs track, the entire pricing mechanism is thrown for a loop.

In late 2008 investors rushed to short-sell financials. Regulatory agencies believed that this short-selling was detrimental to companies like


(C) - Get Citigroup Inc. Report


Bank of America

(BAC) - Get Bank of America Corp Report

who were hammered by the short-selling pressure. Short-selling was banned from some financials and some traders rushed into

ProShares Ultra Short Financials

(SKF) - Get ProShares UltraShort Financials Report

to get synthetically short financial stocks.

The regulatory agencies picked up on the trading volume and tried to stem the flow by announcing that no additional units of SKF could be created. Since market makers couldn't create additional units, the fund traded wildly away from NAV. Traders increased their spreads to broaden out their markets because they could not hedge.

Fast forward to June 2009: Investors begin scooping up shares of

U.S. Natural Gas ETF

(UNG) - Get United States Natural Gas Fund LP Report

at a fast pace. Instead of securities, UNG is made up of natural gas futures. UNG becomes so popular that the fund becomes a significant portion of the natural gas futures market as more and more shares are created.

Again, this influx catches the eyes of regulatory authorities. Because the regulators are concerned that UNG has undue influence over the market, creation has been halted. The fund is now, unsurprisingly,

trading at a premium


UNG and SKF are examples of highly popular commodities and leveraged ETFs. This process of halting creation in commodities and leveraged ETFs is not sustainable. ETF investors will lose faith in the ETF system and regulators will have to constantly step into the flow of the market. Eliminating futures-based ETFs would be a step backward for investors, but many of these funds are not appropriate for most individual investors in the first place.

Futures-based commodity and leveraged ETFs will likely be restructured at some point to lessen their potential effect on the market. The ETF industry is continuing to grow and it is now time to separate futures-based ETFs from the pack with separate classification. Exotic strategies are tempting to investors, but ETF issuers must walk the line.

At the time of publication, Dion had no positions in the stocks mentioned.

Don Dion is the 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.

Dion is also 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.