Natural Gas ETF Protects Self, Not Investors

The refusal of UNG to issue additional shares is a move to protect the fund, not investors.
Author:
Publish date:

WILLIAMSTOWN, MASS. (TheStreet.com) -- The refusal of the U.S. Natural Gas ETF (UNG) - Get Report to issue additional shares is not enough to protect investors. The latest decision from UNG managers is a move to protect the best interests of the fund. Investors should avoid UNG for the foreseeable future until the dust settles.

UNG's rejection of the additional approved units is a significant, if unsurprising, move in an ongoing saga. In early July, fund managers "ran out" of the pre-approved share allotment, forcing a halt in share creation. This jolt

disconnected UNG's market price from its net asset value (NAV)

, forcing the fund to break one of the most important promises made by the ETF industry.

Managers of the fund filed with the SEC for an additional 1 billion shares while the fund itself spent much of July trading at a marked premium. During this period, the Commodities Futures Trading Commission (CFTC) began to examine the role that indexing strategies like UNG had in

the futures markets for commodities like natural gas

.

Sensing that regulation was imminent, managers of UNG began to decrease their position in natural gas contracts and reallocated funds to the purchase of swaps. These swaps trade over the counter and would not be subject to the same regulations as futures trading on the New York Mercantile Exchange.

This restructuring of UNG has changed the essence of the fund. The halt of the creation process has broken the tie between NAV and market price, but the change to swaps alters the nature of the fund entirely. The fund's website asserts that UNG's objective is to track "changes in percentage terms of the price of natural gas delivered at the Henry Hub, Louisiana, as measured by the changes in the price of the futures contract on natural gas traded on the New York Mercantile Exchange."

If the fund now intends to use swaps to deliver a synthetic exposure to its original objective, this goal should be outlined up front. UNG's original strategy was complex and inappropriate for many investors. The fund's new strategy calls into question an entirely new range of risks.

The Wall Street Journal

is reporting that UNG Chief Investment Officer John Highland expects regulation to affect the fund in the short term. "We just don't feel it's prudent to accept

new unit creations and then attempt to use the money to purchase more natural-gas products when we have a strong belief that the CFTC is going to mandate limits that would either cap us or force us to reduce our holdings," noted Highland.

UNG is not the only ETF under fire. Leveraged funds such as

Direxion Daily Financial Bull 3X

(FAS) - Get Report

and

Daily Financial Bear 3X

(FAZ) - Get Report

as well as

ProShares Ultra Short Real Estate

(SRS) - Get Report

have also sparked the ire of regulators, skeptical of sales practices. A number of firms, including

UBS

(USB) - Get Report

and

Ameriprise

(AMP) - Get Report

, have halted the sales of such products to their clients.

The scrutiny of these funds has been led by the Financial Industry Regulatory Authority (FINRA)

.

The alphabet soup of regulators seems to have one goal in common: ETFs that use futures to achieve objectives may not be appropriate for most retail investors. A joint effort by the SEC, CFTC and FINRA to understand and regulate these funds would simplify the struggle.

ETFs are designed to track an underlying index through the creation and redemption of shares. Regulators or issuers that step into the flow of oncoming trading actually

risk disrupting the central tenants of ETF ownership

.

Traditional ETFs should be

treated separately and classified apart

from nontraditional products through an organized regulatory effort. If a disruption occurs, as in the case of UNG, trading should be halted until it can normally resume. ETFs are a useful tool but only when allowed to operate properly.

-- written by Don Dion in Williamstown, Mass.

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

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.