A Word of Caution About These Endangered Investments

Nathan Slaughter's picture

Thursday, September 10, 2009 - 4:04pm

by Nathan Slaughter

A good deal of political turmoil has surrounded the exchange-traded fund (ETF) world in recent months. The powers-that-be have been tightening the regulatory noose around certain commodities and leveraged funds. This has created headaches for fund issuers and millions of individual investors that have a stake in them.

As this fluid situation changes by the day, we here at StreetAuthority have decided to weigh in on the topic and provide timely guidance to our many subscribers that hold ETFs in their portfolios.

To understand the current climate, we must first backtrack to the summer of 2008. Oil prices ascended to dizzying heights near $150 per barrel and drivers grumbled about paying $4 for a gallon of gas. Regulators tried to pin blame for skyrocketing prices on institutional speculators -- namely hedge funds and bank trading desks.

Now they have turned their sights to the new kids on the block, ETFs.

Investors have poured billions of dollars into a growing number of commodity ETFs -- trying to harness quick profits that can come with sharp moves in oil, natural gas, metals and agricultural products. Some of these funds, like the popular SPDR Gold Shares (NYSE: GLD) are designed to track spot prices by storing actual bullion in their vaults. Others aren't equipped to hold the physical commodities, so they instead rely on futures contracts.

It's this second class of funds that has drawn scrutiny from the Commodities Futures Trading Commission (CFTC). Emboldened by research suggesting potential manipulation in the wheat market back in 2007, the CFTC has been diligently monitoring ETF trades. The government isn't worried about fraud -- it's the disproportionate impact these huge funds can have over smaller, less liquid markets.

To keep trading orderly and prevent commodities markets from artificially inflating or deflating, regulators have decided to step up the policing of ETFs. In many cases that has meant the imposition of strict limits on position sizes. Sweeping repercussions have followed.

Not long ago, PowerShares DB Crude Oil Double Long (NYSE: DXO) was forced to shut down and return money to shareholders. Meanwhile, some portfolio managers have chosen to go to plan 'B' and pay premium prices for over-the-counter swap contracts. Others have had to seek out new markets to get orders in (moving from the Chicago Board of Trade to the Minneapolis Grain Exchange, for example). These unusual moves have increased tracking error and hampered performance.

Another unwelcome side effect is the disruption to the creation/redemption mechanism that keeps ETF share prices and portfolio net asset values (NAVs) in balance. That's why U.S. Natural Gas (NYSE: UNG) is now trading at a 15% premium -- essentially forcing retail investors to pay a hefty markup to the actual commodity price.

It seems likely the axe will fall on more funds, particularly those narrowly focused on one commodity. Recently, CFTC chairman Gary Gensler lobbied congress for $180 billion in annual funding, with much of that earmarked for sophisticated computer tracking systems.

So is all of this the act of overzealous regulators thwarting everyday investors, or prudent overseers doing their job and keeping prices in check?

I believe some regulation is in order to prevent large funds from dominating markets rather than simply tracking them. But there is a danger the CFTC could overstep -- any real threat of manipulation isn't coming from the transparent portfolios and strategies of ETFs. Furthermore, limiting position sizes is nothing more than a symbolic gesture -- new funds will inevitably rise and pick up the slack. So instead of one giant fund with $5 billion in assets, we might see five smaller funds with $1 billion each.

The bigger question is whether you should be investing in these funds in the first place.

With rare exceptions, I advise against futures funds. Aside from the increased regulatory hassles and potential counterparty risk, there is the corrosive long-term impact of contango -- where the price of a commodity futures contract is actually higher than the spot price. Unlike a static portfolio of stocks and bonds, futures contracts are always expiring, which means owners must continually sell out and "roll" the proceeds into a further dated contract.

Unfortunately, as you can see from the current scenario in the natural gas market, commodity prices often rise (in relation to current spot prices) as you go further out.

Contract Price
Henry Hub Oct. '09 Delivery $2.73
Henry Hub Nov. '09 Delivery $3.74
Henry Hub Dec. '09 Delivery $4.50
Henry Hub Jan. '09 Delivery $4.80

Therefore, these funds are systematically selling low as positions expire and buying high as the money rolls into new futures contracts. This phenomenon can erode (if not offset) any gains in the underlying commodity over time. And to rub salt in an open wound, opportunistic front-runners know exactly when ETFs must buy and sell, so they capitalize by acting first, which also works against futures funds.

Keep in mind, these funds aren't investing in a portfolio of real companies with tangible assets and profits -- they are just betting that prices will move in a certain direction. This isn't investing, it's speculating. And in this zero-sum game, you are playing against much larger and more experienced players.

None if this is to say commodities can't and shouldn't occupy a valuable spot in your portfolio. Not only can they be a valuable diversification tool because of their historically low correlation to other asset classes, but they have compelling fundamental tailwinds as well. If you believe in commodities, then the companies that grow them or dig them out of the ground are usually your best bet.

These businesses can turn any increase in prices into even stronger gains on the bottom line, thanks to operating leverage. A company like Goldcorp (NYSE: GG) might convert a modest +10% uptick in gold into a +20% (or better) jump in earnings. If prices happen to stay flat or decline, these companies can still rake in cash and pay out generous distributions. Futures contracts have nowhere to hide, and they definitely don't pay quarterly dividends.

We've seen those advantages come into play this year. For example, the Market Vectors Hard Assets Producers ETF (NYSE: HAP), which invests in the companies that give us vital things like copper, natural gas, grains, and timber, has been one of the biggest winners in our "Sector Trading" Portfolio. The fund has delivered an impressive year-to-date gain of +29.1% -- versus just +4.0% for an all-futures substitute like PowerShares DB Commodity Index (NYSE: DBC).

There has also been trouble brewing over another class of funds -- those that use leverage to amplify either the returns of a given benchmark or its inverse. I warned my ETF Authority investors to read between the lines on these tricky securities last March, and now officials are throwing the red flag as well. Some brokers like Edward Jones have gone so far as to restrict clients from buying them altogether. It's easy to see their concern.

Just look at the Ultra Oil & Gas ProShares (NYSE: DIG) and the UltraShort Oil & Gas ProShares (NYSE: DUG). The long version tumbled -70% last year as the price of oil collapsed. So you'd think a fund designed to move in the opposite direction would have soared. Wrong. It actually declined about -10% as well. Because of the vagaries of compounding, investors using these funds for anything other than day trading can correctly predict which direction an index is headed and still lose big.

ETF innovation has given investors more choices than ever before. The long and short of it is that many investors lack the expertise to use these new funds as they were designed and rushed headlong into complex products that wrecked their portfolios. That doesn't mean leveraged funds aren't viable products -- and the last thing we need is government bureaucrats telling us where and how to invest.

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.