Natural Gas ETF Has Its Drawbacks - TheStreet

Editor's note: Don Dion is the president and chief investment officer of Dion Money Management and the publisher of the Fidelity Independent Adviser family of newsletters. He provides commentary on exchange-traded funds and mutual funds.

The

United States Natural Gas

(UNG) - Get Report

exchange-traded fund has ballooned in recent weeks and has now hit a threshold where the problems inherent in the fund and the limitations on the natural gas market raise concerns for investors and regulators alike.

The most recent move on the part of the fund's managers has been to cut back futures holdings in what may be an effort to keep the net asset value of the fund in line. As ETF investors jump to get on the natural gas bandwagon, they should consider the drawbacks to UNG and available alternative investments.

1.

Construction

UNG invests in front-month natural gas futures contracts that trade on the New York Mercantile Exchange. The value of the contracts is tied to the spot prices for natural gas delivered at Henry Hub, La. Natural gas is difficult to transport, so futures provide a good trading environment for investors unable to own the commodity directly. As the calendar catches up with the contracts, investors are forced to "roll forward" their investments into a later date, so UNG rolls its current contracts into the next month's contracts on a regular basis.

For example, if you own $1 billion worth of July contracts today, theoretically, you stand prepared to take delivery of the equivalent amount of natural gas in July. Imagine the reality of the situation: No one actually expects to have a tractor trailer full of natural gas show up in his driveway when the contracts expire, so he "rolls" the investments forward into the next month, and so on, as long as he desires to track the price of natural gas. UNG does this for its investors as part of its methodology.

2.

Can you dance contango?

While the idea sounds complex enough, "rolling" forward contracts is not as simple as turning in your July contracts for August contracts.

Consider the following example noted by Morningstar analyst Paul Justice: "

UNG lost 12% of its value during the summer of 2007 even though natural gas spot prices gained 1% over the same time period. Why the disparity? This fund mostly invests in near-month futures contracts. As each month draws to a close, the fund rolls over to the next month's contract, and so forth. When the prices of those out-month contracts exceed the price of the near-month contract (known as a state of "contango"), the fund loses money each time it rolls futures. That explains why this fund has oftentimes declined in value even as natural gas prices rose, as the natural gas futures market was in contango at that time."

Contango slowly rots away the value of your initial investment over time as one month rolls to the next. The winners in this situation are traders with access to both paper and physical commodities, not UNG holders.

3.

All of Creation

The size of UNG used to occupy 40,000 natural-gas derivative contracts on May 20, but the fund expanded to about 90,000 contracts just last week, according to the

Financial Times

. As the demand for UNG rises, authorized market participants (modern-day ETF specialists) create units of the fund to sell to individual investors in large blocks. Since they are not allowed to stay "short" the fund for long, these authorized participants are constantly trying to create enough shares ahead of time to anticipate the market's demand.

How do they create these shares? Authorized market participants deliver the securities in the underlying basket, or equivalents, in exchange for blocks of the fund. A

Dow Jones

report said that interest in UNG has expanded so rapidly that the fund now wants to issue 10 times the number of shares now available.

UNG is designed to track the value of these futures contracts, not the other way around -- concern that regulators had with a similar fund,

United States Oil

(USO) - Get Report

, earlier this year. The holdings in funds like USO and UNG can get so large that the funds actually move the markets for the contracts when the fund managers roll the contracts to the next month.

The latest reports note that UNG's managers are cutting back the fund's futures holdings even as interest in the fund is approaching fever pitch. One reason is that the fund is getting ready to roll, and this cutback is a normal phenomenon. Another potential reason, however, is that the influx of assets into UNG, and the fund's ever expanding grip of the futures markets that it tracks, is coming under USO-like scrutiny. If regulators begin to sense that UNG is bullying the market for natural gas, the value of the fund could suffer under increased regulation. In place of buying futures, fund managers have switched their attention to swaps.

5.

Available Alternatives

ETFs have attracted a tremendous amount of attention because of their transparency and ease of trading, but this image may lead to an oversimplified perception of funds like UNG. Commodity ETFs that are made up of underlying futures contracts have to battle issues that equity ETFs avoid.

Investors should view commodity ETFs and all exchange-traded notes in a separate category from plain-vanilla equity ETFs. While warning labels do exist, the complexities of commodity ETFs and ETNs are often glossed over by issuers eager to market alternative investments to a crowd that is willing to break away from the equity markets.

There are ETFs, however, for investors who wish to participate in trends such as agriculture, gold and natural gas without holding complex securities and difficult-to-understand ETFs. Stock-based ETFs are available for investors willing to participate in trends like agriculture, gold and natural gas through the stocks of companies that produce commodities. UNG's stock-ETF equivalent is

First Trust's ISE-Revere Natural Gas

(FCG) - Get Report

.

In gold, the physical commodity fund is

SPDR Gold Shares

(GLD) - Get Report

, while its stock-based ETF equivalent is

Market Vectors Gold Miners

(GDX) - Get Report

ETF.

In agriculture, the futures-based fund is

PowerShares DB Agriculture Fund

(DBA) - Get Report

, while the stock-based ETF is

Market Vectors Agribusiness Fund

(MOO) - Get Report

.

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