New Hurdles Loom for Commodities ETFs

Surging retail demand for ETFs and ETNs has the CFTC and the SEC enforcing strict position limits, sowing confusion and talk of new instruments

By David Bogoslaw

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.

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