NEW YORK (TheStreet) -- Investors who want to invest in natural gas futures have two choices in the U.S. market: United States Natural Gas (UNG) - Get Report and the iPath Dow Jones-UBS Natural Gas Total Return Subindex ETN (GAZ) - Get Report.
UNG and GAZ offer investors exposure to natural gas futures contracts. Unlike the precious metals, these funds do not store gas, and that has been a sore spot for investors in 2009. Futures contracts cannot be bought and held; they must be "rolled" each time the contract expires.
UNG uses a monthly roll strategy whereby it buys the near month contract and then rolls to the next contract before expiration. Investors can go to the Web site of the United States Natural Gas fund and find the roll dates under the "Fund Facts."
GAZ is a note that tracks the Dow Jones-UBS Natural Gas Total Return Sub Index. It uses a similar strategy to UNG, but instead of rolling monthly, it rolls bi-monthly. Since GAZ is an ETN, it doesn't list what contracts it owns, if any. Barclays stands behind the notes and is responsible to make payments on the contracts, and a purchaser of GAZ is lending Barclays money the same as other bond holders. Barclays is not restricted in how it can use the capital and investors face the same risk as other holders of Barclays debt.
One important difference between UNG and GAZ, besides the credit risk in GAZ, is the tax implications. UNG is a partnership that pays no Federal taxes itself. Gains or losses are passed through to shareholders. Investors receive a Schedule K-1 and may have tax credits or liabilities even if they receive no income payments. GAZ is similar to other stocks in that income payments would be reported on a Form 1099 and capital gains and losses are incurred at the sale. Neither UNG nor GAZ has paid dividends.
Head to Head
In terms of strategy, the funds almost perfectly tracked each other from inception until August of this year (they separated for reasons discussed below), suggesting no clear advantage for one over the other.
Individuals concerned about taxes can consult a professional, as either may be appropriate, given individual circumstances. Investors in tax-sheltered accounts may consider either fund.
As for credit risk, it favored UNG until the fund began buying swaps (more below). Now it is a push.
UNG charges 0.97% fees and has a three-month average daily volume of 42 million shares. GAZ charges 0.75% and has a three-month average daily volume of 650,000 shares. On this score, GAZ's volume is adequate for all but the largest investors, and the lower fees make it more attractive.
A major issue that erupted in summer 2009 was the popularity of UNG and concerns over new CFTC regulations on position size. First, UNG was forced to purchase swaps because it became a huge portion of the market for near month gas futures contracts. Swaps carry counterparty risk, however, which causes it to have similar credit risk to GAZ, albeit less transparent. Concerned that the CTFC may limit how many contracts they can own, both UNG and GAZ stopped issuing new shares. This led to a premium in both funds.
The premium fluctuates daily. As of this writing they are similar, about 10%, but UNG has traded at a higher premium at times, briefly reaching a peak of 20% at one point. If the funds begin issuing shares again, the premium will disappear almost instantly.
You can check the premiums during trading on Yahoo! Finance by finding the intraday indicative value of the fund. Enter ^UNG-IV or ^GAZ-IV as the symbol and compare it to the last price; it is updated throughout the day. (You can substitute any ETF or ETN symbol to get its intraday indicative value.)
Another issue to
. Futures contracts can be in contango or backwardation. Contango refers to the situation when near-month contracts are cheaper than contracts farther out in time. Backwardation is the opposite, when near-month contracts are more expensive.
Since futures contracts have an expiration date, it is impossible to buy and hold. Commodity trading strategies take this into consideration and determine which contracts promise the best return. In the case of UNG and GAZ, the funds use a simple strategy that exposes them to gains or losses, depending on where there is backwardation or contango.
For instance, say natural gas for October delivery costs $2 and natural gas for November delivery costs $4. If a trader holds 1,000 contracts at $2 and rolls monthly, he will only hold 500 contracts after the roll, assuming no transaction costs. This became a major issue with UNG because it grew to such a large size.
When UNG rolls, its selling and buying cause the contango to widen, and since it publicly announces its roll dates, other traders can profit from UNG's "largesse." UNG shareholders suffered losses as they sold at lower prices and bought at higher prices. Currently, contango is especially large, due to several factors, which I have written about previously, and this makes this situation even worse.
Strictly speaking in terms of a head-to-head comparison of these two funds, ignoring whether natural gas is a buy or sell, ignoring the contango and ignoring whether it makes sense to pay a premium, GAZ is currently the better choice between these two funds.
-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion held no positions in companies 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.