Surging retail demand for ETFs and ETNs has the CFTC and the SEC enforcing strict position limits, sowing confusion and talk of new instruments
Momentum appears to be building for financial regulatory reform in Washington as officials trumpet the need to offer extra protection for small investors. But for some investors in exchange-traded funds and notes that focus on commodities, the increased oversight may actually work against them.
Investors consider ETFs and ETNs to be effective vehicles for gaining exposure to commodities in their portfolios. But their popularity may be working against them. Commodity ETFs and notes have to buy more underlying commodity futures contracts in order to be able to issue additional shares—and there's growing concern at the Commodity Futures Trading Commission (CFTC) that the deluge of money pouring into these ETFs and ETNs from retail investors may be distorting market prices. So far most of the attention is focused on certain energy and agricultural products, but that's enough to cause prices of ETFs that track broad commodity indexes to veer far from the funds' net asset values, making them less attractive than they were.
That's not the only difficulty faced by the asset class. On Aug. 12, the United States Natural Gas Fund (UNG) was the first ETF to stop issuing new shares out of concern that it might already be exceeding strict position limits—the number of futures contracts it's allowed to hold—that the CFTC may impose in the near future. The U.S. Securities & Exchange Commission subsequently approved a fund registration statement requesting permission to issue up to 1 billion additional shares. But in an Aug. 12 SEC filing, the fund's officers said that rather than issue new shares, they are looking for other natural gas-related instruments to buy, including cash-settled options on futures contracts and over-the-counter swaps based on the prices, futures contracts, and indexes of natural gas, crude oil, and other petroleum-based fuels. That would allow the fund to maintain its exposure to the natural gas market with a reduced number of futures contracts.
Deutsche Bank's Mixed Response
On Aug. 18, Deutsche Bank (DB) said it was temporarily suspending further issuance of the PowerShares DB Crude Oil Double Long Exchange Traded Notes and warned that the suspension could cause fluctuations in the notes' trading price. Although the bank didn't explain the move, it's likely to have acted in anticipation of a CFTC ruling that would shut down very aggressive commodity products that the CFTC believes may be distorting market prices. Earlier that day, the SEC and the Financial Industry Regulatory Authority (FINRA) had issued a joint warning to investors against the use of leveraged ETFs.
Significantly, Deutsche Bank has not halted the issuance of new shares of either of its commodity ETFs—PowerShares DB Commodity Index Tracking Fund (DBC) or the PowerShares DB Agriculture Fund (DBA)—both of which will soon be affected by position limits imposed by the CFTC because of the rescinding of a no-action letter granted to the two funds in 2006. The letter had exempted them from federal limits on speculative positions in their corn and wheat holdings on the Chicago Board of Trade (CBOT). (The reversal of the no-action letter takes effect on Oct. 31.)
On Aug. 24, Barclays Global Investors announced that it was temporarily suspending creation of new shares of the iShares S&P GSCI Commodity-Indexed Trust (GSG). Christine Hudacko, a spokeswoman for BGI, believes the furor over commodity ETFs is more about the structure of the underlying commodity futures market—and the likelihood of changes in that structure because of impending regulatory action—than about ETF products themselves.
"We have gotten increased interest most recently" from new investors, but there's no way to know whether that's a direct result of the reversal of no-action letters for rival commodity ETFs, she says. While the iShares ETF hasn't hit its position limit of 40,000 contracts on the Chicago Mercantile Exchange, that may be because the fund didn't want to risk getting too close.
Fund Managers Query Position Limits
Recently appointed CFTC Chairman Gary Gensler said in an Aug. 19 news release that "position limits should be consistently applied and vigorously enforced" and that "position limits promote market integrity by guarding against concentrated positions."
But some fund managers who own shares of commodity exchange-traded products in their portfolios say they're less inclined to use them if position limits are imposed.
"If the price of an ETF got too far above the price of underlying [securities], authorized participants could just go out and create additional shares. If you can't create additional shares, then there's no real mechanism to get the ETF back to the net asset value, and that holds for ETNs as well," says Scott Kubie, chief investment Strategist at CLS Investments in Omaha. "We're starting to see some premiums in the marketplace, trading above the NAV. Even if they're not, they certainly run the risk of it in the future."
That makes commodity ETFs less compelling to investors seeking market efficiency and also makes them harder to analyze, Kubie says. When the price stays close to the NAV, it's accessible at any time. "Now you have to gauge the movement of the NAV and the movement of the premium to figure out what your total return will be," he says. "Now you have to focus not just on your allocation but on some characteristics of supply and demand."
Louis Kokernak, a financial adviser at Haven Financial Advisors in Austin, Tex., says a CFTC ruling on position limits would make him stay away from products that have restricted shares, at least in the short term, in order to avoid paying a premium. He probably wouldn't exit any of the positions he already holds, however, because he expects any premiums that result from position limits to work to the benefit of shareholders.
Effect on Traditional Mutual Funds?
William Rhind, head of sales and marketing at ETFS Marketing, U.S. marketing agent for ETF Securities—which in July launched its first commodity ETF in the U.S., the ETFS Silver Trust (SIVR)—calls the possibility of position limits "less than optimal" for existing commodity ETFs that would no longer be able to create additional shares to shed price premiums to NAV. But rather than being a discouragement, he says it "probably strengthens our desire" to roll out commodity futures-based products in the U.S., given that new investors will need additional funds to invest in if existing ETFs aren't permitted to continue to grow.
Given that the CFTC isn't targeting ETFs per se, but wants to remove all speculators—anyone not hedging a physical position—from the commodities market, it's fair to assume that position limits would also have consequences for traditional mutual funds such as the Pimco Commodity Real Return Strategy Fund (PCRIX), which gets exposure to the benchmark Dow Jones-UBS Commodity Total Return Index through commodity-linked notes.
A Pimco spokesman said in an e-mail that the company isn't commenting on CFTC developments right now.
Rick Miller, founder of Sensible Financial Planning and Management in Cambridge, Mass., says it's nonsense for the CFTC to try to restrict access to commodities to only those players willing to take delivery of the physical products.
The Culprit: Retail Investor Demand
"What is it these markets are doing? They're providing price insurance. People who buy commodity futures are trying to lock in prices of commodities that they're ultimately going to use," he says. "Should we restrict capital markets so that only people who are willing to take insurance risk are willing to participate? The genius of capital markets is we allow risk to get spread around."
Kathleen Moriarty, a partner at Katten Muchin Rosenman in New York, who focuses on financial-services matters, sees regulators grappling with a changing investment landscape in which there's been a surge of demand among retail investors who had no interest in commodities as recently as a few years ago. The fact that the CFTC and SEC plan to seek feedback from financial industry lawyers and market participants during public discussions to be held next week suggests that they haven't yet concluded what the best course of action will be.
Whatever solutions are ultimately put in place may simply drive fund developers into other instruments if demand for these products continues to increase. "Any of these [restrictions] is like putting up a dam on a river. The dam will divert the river if [the river's] strong enough," says Moriarty. "You wonder whether erecting the dam is a good idea or not—and is there something better to keep the river from overflowing?"
The CFTC, depending on how many loopholes it closes, will end up pushing commodity funds into "a darker corner where the investor doesn't know as much about what his fund holds," predicts Matt Hougan, director of ETF analysis at IndexUniverse.com. The counterparties in the privately negotiated swap agreements that United States Natural Gas Fund has begun to use, for instance, are required only to be disclosed in a fund's prospectus every six months—not daily—and offer far less transparency than knowing how many futures contracts a fund holds, he says.