New Nat Gas ETF for the Long Haul

U.S. Natural Gas ( UNG) soon may have a sibling in the form of the U.S. 12-Month Natural Gas fund. The new fund is designed to reduce the effects of contango by spreading the contract purchases over a 12-month period.

Instead of putting all the assets into one contract and rolling the total assets every month, the new fund will roll from the contract facing expiration and purchase the contract 12 months out.

The new ETF is a result of the success of UNG, which grew so large that it was distorting the market and exacerbating contango, the phenomenon of far future delivery prices exceeding those of a nearer future delivery.

UNG is the 800-pound gorilla in the natural gas futures market, with a clearly defined strategy that traders can exploit.

By spreading contracts over 12 months, the new ETF can reduce its footprint in any single month. Size could become an issue again because the contracts further out in time tend to be less liquid.

United States Commodity Funds already dealt with this issue when it issued the U.S 12-Month Oil Fund ( USL) to trade alongside its flagship fund, U.S. Oil ( USO).

USL's contango-fighting strategy was evident starting last fall, when it became a serious issue. Between its inception in December 2007 and November 2008, USL and USO closely tracked each other but separated as spot prices tumbled. From Nov. 7 to Feb. 18, USO fell 54% compared to a 39% drop in USL. Recently, USO outperformed slightly as contango declined, but over the past month the funds were back to moving in lockstep.

Despite USL's contango-fighting structure, investors are uninterested. USO had roughly 14 times the assets of USL and 85 times the volume as of the end of May. The difference between the two ETFs highlights a problem with financial markets and one of the difficulties with ETFs.

Just because an ETF has low volume does not mean it is an inferior product. On the flip side, we've seen the countless occasions over the years that prove the herd is often wrong, most recently in housing. It is a Catch-22 for investors -- accept the liquidity risk and dive into a superior product or join the herd in the inferior one?

This also brings to mind a great report by fellow contributor Howard Simons pertaining to commodity differences vis-à-vis stock indices. It greatly details the differences between the two, and I can't do it justice in brief, but one conclusion that all investors need to have drilled into their heads is that commodities do not behave like stocks.

The fact that superior products such as USL, and the even more superior DBO have far lower volume than USO shows one of two things. One is that these aren't investors but rather traders who are taking short-term positions. In that case, go with the high-liquidity product and make sure to get out before the roll dates (available on the issuer Web site). The other is that many investors do not understand what they are buying but instead follow the herd into high-volume products.

When the choice is between two similar ETFs, such as oil drillers or biotechnology, choosing the fund with superior liquidity is often a good strategy, but when dealing with commodities, the strategy of the funds is just as important. Commodities are traded, not bought and held, but if you are looking to play a multimonth or multiyear trend, then you need to buy the products that offer superior trading strategies.

In all likelihood, the new U.S. 12-month Natural Gas ETF will have much lower volume than UNG. Short-term traders can stick with high-volume UNG, but investors looking to hold for more than a period measured in days or weeks should migrate to the new fund. When dealing with low liquidity funds, use smaller order sizes and scale into a position, and be mindful that you may have difficulty making a quick exit.

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.