Game Over for USO, UNG

Commodity ETFs have been criticized from all corners. Investors have pilloried their inability to accurately track the price of their underlying asset. Industry watchdogs have assailed their inadequate disclosure of risks. And regulators have fretted over their ability to unduly manipulate futures markets.

Yet ETFs like the United States Natural Gas Fund (UNG) and the United States Oil Fund (USO) seem to have thus far gotten away high fees, poor disclosure, and disappointing returns, as investors are still buying them in droves. But regulators are less happy, and commodities-futures ETFs may not survive the coming regulatory onslaught.

Bloomberg is reporting today that the Commodity Futures Trading Commission (CFTC) will open hearings into expanding regulation of speculative trading in commodities. Although the hearings concern all speculators, the regulators are primarly concerned with USO and UNG’s ability to move the oil and natural gas markets higher, adding a speculative premium to energy prices. Trading in the UNG was breifly halted as the SEC denied its routine request to issue more shares.

Ironically, with the USO and UNG, investors get the worst of both worlds. The funds themselves don’t track the price of the commodity very well due to rollover, so investors don’t reap the rewards of higher prices. But many believe their trading nonetheless increases demand for the contracts, driving spot prices prices higher. Not only do the UNG and USO screw you out of your returns, they make filling up and heating your home more costly. The only people who benefit from this scheme are the ETF issuers who collect the fees, and the speculators who actually play the futures markets properly.

The CFTC is considering putting limits on holding futures contracts, which could take a variety of forms including limiting the number of trades or contracts any one market participant can hold.

Such a move would directly threaten commodity futures funds, and could force many of the largest ones to close up shop. It would be difficult to keep the size of any ETF down to a particular number of trades or contracts because ETFs are supposed to be open-ended, issuing new shares and aquiring new assets to match as investors put money in. Keeping a commodity ETF within regulatory limits, therefore, will essentially force it to become a closed-end fund that trades at a discount or premium to its net-asset value.

Such funds already exist, but are nowhere near as popular as their exchange traded peers precisely because their values fluctuate in such a seemingly random fashion. And the CEFs don’t solve the rollover problem found on ETFs, as the don’t have fixed end dates to match those of their underlying contracts.

In fact the UNG today entered such a closed-end situation as the CFTC failed to approve its request to issue additional shares pending the outcome of its hearings, meaning the fund that was already a messy way to play natural gas has become a downright terrible one.

Although Exchange Traded Funds are wonderful creations, they simply cannot invest in futures markets. There is an inherent and irreconcilable clash between an ETFs’ open-ended structure and the closed-end and fixed-date nature of futures contracts. An Exchange Traded Fund will never be able to accurately track the price of a commodity by investing in futures. Only those that invest in the physical asset – like the GLD, SLV, and several commodity ETFs traded in London are able to do that at the moment.

Yet funds like the USO and the UNG would have you believe otherwise. They attract assets with misleading marketing and fail to provide investors the product they expect. Its a hugely profitable business, but collecting fees on a mislabeled product is ethically dubious and investing in such funds can be investing suicide if you don’t know the risk. Greater regulation is needed and coming, the only question now is whether it leaves these ETFs simply out of luck or out of business.

If anyone can figure out an exchange traded investment product that can actually track commodity prices through futures, it’d be a wonderful tool to play the whole asset class. But the current class of commodity futures ETFs can be terrible intstuments which generate fees and little else. The investment industry as a whole needs to be more honest about these funds, but unfortunately most investment advisers seem clueless about the USO and UNG.

On the day before the CFTC announced it was investigating these dubious funds and trading in the UNG was halted, ETF “gurus” were on national television praising thier virtures; which is kinda like recommending Fairfield Greenwich on Dec. 9, 2008.

Its time for some honesty and integrety in the ETF marketplace. I’d rather have self-regulation, and if the government has to force disclouse and limits on these funds than so be it.