Commodities ETFs Squeezed by Uncertainty
Call it collateral damage. Efforts by regulators to curb speculation in the futures markets have created unintended consequences for investors in commodity-oriented exchange-traded funds and notes. Few of these products actually hold physical stuff. It would be impractical for managers to store barrels of crude oil or bushels of corn. Instead, most ETFs and ETNs use derivatives, usually futures contracts, to simulate the returns of a commodity or commodity index.
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The use of futures has made large ETFs and ETNs targets for regulators. The mess started on August 19, when the Commodity Futures Trading Commission revoked exemptions from limits on the futures positions of two ETFs: PowerShares DB Agriculture (symbol DBA) and Powershares DB Commodity Index Tracking (DBC). The commission expressed concern that the funds' positions in the futures markets for grains had grown too large.
The commission's action caused a stir among other commodity funds and notes. Fearing tighter limits on more futures positions, some sponsors stopped issuing shares. By doing so, their ETFs became similar to old-fashioned closed-end funds, which issue a fixed number of shares, then trade on exchanges.
One attribute of closed-end funds is that their share prices can trade above or below the value of a fund's underlying assets, or net asset value per share. Because some ETFs stopped issuing new shares even as demand for commodity investments remained strong, the prices of a few ETFs have risen above their NAVs. For example, at its September 8 closing price of $10.28, shares of United States Natural Gas (UNG), one of the ETFs that had suspended issuance of new shares, traded at a 19% premium to its NAV.
Four other exchange-traded products stopped creating new shares: United States Oil (USO) and iShares S&P GSCI Commodity-Indexed Trust (GSG), both ETFs; and PowerShares DB Crude Oil Double Long (DXO) and iPath Dow Jones-UBS Natural Gas Subindex Total Returns (GAZ), both ETNs. Unlike an ETF, which buys the underlying futures contracts, an exchange-traded note is essentially a bond that promises to pay a return identical to the futures plus interest on cash collateral for the contracts.
The sponsor of one exchange-traded note that suspended shares is throwing in the towel. Deutsche Bank has announced that it will redeem all outstanding shares of its PowerShares oil ETN, which seeks to return twice the change in a crude-oil index on a daily basis. On September 9, Deutsche Bank will give investors cash equal to the NAV of each share they hold. Investors who purchased shares at a price above the ETN's NAV will see that premium erode, although it's still possible for them to make money if the price of oil rises during the time they hold the note. The ETN recently had $426 million in assets.
The CFTC is expected to decide position limits for exchange-traded products by the end of September. "We don't have specifics of what those limits will be," says John Hyland, chief investment officer of United States Commodity Funds, which sponsors the oil and natural-gas ETFs. "We assume that large commodities ETFs will have to own fewer commodity futures contracts than they own today."
Steep premiums on the funds and notes that have already suspended or may suspend issuance of new shares are likely to dissipate when the commission makes its decision. And some of those sponsors might follow in Deutsche Bank's footsteps and liquidate their products. It's best to wait until the smoke clears so you can get a better look at the commodity-based ETFs and ETNs left standing.