Commodities Crackdown Could Curb ETFs

Strict position limits on commodities trading could curb the development of ETFs like U.S. Oil (USO) and U.S. Natural Gas (UNG). ETFs currently use an exemption to give investors access to complex futures markets, but regulators are beginning to question whether investors should be there in the first place.

In the first of a series of hearings on commodities position limits, Commodities Futures Trading Commission (CFTC) Chairman Gary Gensler spoke to ETF investors when he asserted that speculation by index investors contributed to soaring commodities prices last year. ETFs rely on a "bona-fide hedging exemption" to structure products that offer investors a way to participate in commodities prices.

Over the last decade ETF products have opened up markets to retail and institutional investors alike, prompting a massive influx of funds to previously inaccessible areas such as commodity futures. Currently the CFTC sets hard position limits on some agricultural commodities while letting exchanges dictate limits on all other products.

This distinction has not been lost on ETF issuers who would like to use their exemption to offer investors access to the entire commodities market. In a June letter to the CFTC, the managers of UNG and USO asked officials to extend the bona-fide hedging exemption to all commodities.

The CFTC and SEC, however, have other ideas. The CFTC hearings suggest that regulators could expand regulatory reach in the commodities markets to crack down on speculation. Even if the price of certain commodities is set by exchanges, the CFTC could curb positions.

The managers of UNG and USO have anticipated regulatory changes and made moves to mitigate the effects that any regulation could have on their funds. In a June letter to the CFTC, managers of USO and UNG requested that "any future regulation of the commodity futures market should codify the CFTC's no-action position with respect to the activities of index-based tracking funds."

The CFTC, however, is not the only regulatory agency on the trail of these products. On July 7 UNG literally reached its position limit when it ran out of shares to offer investors. When the managers of UNG filed to create one billion new shares of the fund, the SEC stalled. Since a fund's creation and redemption process keeps the market price in line with its underlying value, this move has put shares of UNG in a kind of ETF purgatory.

UNG managers, however, have not sat idly by. Where there is a will, there is a way, and UNG managers are taking on increasingly risky strategies to extend their fund to investors. Most recently, UNG managers purchased a large over-the-counter swap as the fund's structure drifts further away from its stated objective.

Potential regulation is not the only problem facing UNG investors. To hear more about why USO and UNG do not work as advertised, see video below.

Oil ETF Not a Pure Play

The managers of UNG and USO have been quick to contradict claims that their funds have undue influence on the commodities market. Comments from CFTC General Counsel Dan Berkovitz indicate that the CFTC does not have to wait around for proof before acting. During the first hearing on commodity position limits, Berkovitz noted, "you don't have to wait for some damage to the market or some undue burden on commerce."

ETFs have made great strides in allowing investors access to previously inaccessible areas of the market. The next step is to have separate classification of non-traditional ETFs and ETNs and investors education. Investors, meanwhile, do not want to get caught in the regulatory maelstrom.

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.

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