Trading of UNG Halted When Shares Run Out

Trading was halted briefly today on  United States Natural Gas (UNG) when the exchange-traded product's issuing company announced that it can no longer accept creation baskets to create new shares of the fund. For investors, this means that the arbitrage mechanism that keeps the shares trading close to the value of the securities held is no longer functioning properly, and the existing shares may begin trading in a similar fashion to closed-end funds. This could result in large deviations, either premiums or discounts between the share price and the index value.

The company applied for 1 billion new shares early in June, and it is still awaiting approval from the Securities and Exchange Commission, Commodities Futures Trading Commission, Financial Industry Regulatory Authority, and the National Futures Association. However, we are not certain that the approval will come anytime soon. The CFTC today issued a statement that it will be seeking views on applying position limits consistently across all markets and participants, including index traders and managers of exchange-traded funds.

The assets invested in UNG have ballooned this year, growing from roughly $700 million in January to nearly $4 billion today. To put that in perspective, earlier this month, the front-month open-interest in natural gas on the NYMEX was only approximately $2.8 billion.

The popularity of this fund, as well as its sister fund that uses a similar strategy in the oil patch,  United States Oil (USO), has not gone unnoticed by institutional traders. Several trade publications and "sell-side" firms issue alerts so traders on the floor can anticipate the timing and size of the contract "rolls" ahead of time. Whether or not this has impacted retail investor returns is difficult to determine, but we anticipate that the matter will lead to further review.

How UNG Is Supposed to Work
Investors should be mindful that this fund invests in natural gas futures and not the spot price of natural gas. UNG systematically "rolls" its assets every month from a contract a few days from expiration and into the contract with the next closest expiration, which expires one month later. Because of market liquidity and the absence of carrying costs, using futures is in many aspects a better way to invest in natural gas than owning the commodity directly. However, the strategy does have some flaws. For instance, this fund lost 12% of its value during the summer of 2007 even though natural gas spot prices gained 1% over the same time period. Why the disparity? This fund mostly invests in near-month futures contracts. As each month draws to a close, the fund rolls over to the next month's contract, and so forth. When the prices of those out-month contracts exceed the price of the near-month contract (known as a state of "contango"), the fund loses money each time it rolls futures. That explains why this fund has oftentimes declined in value even as natural gas prices rose, as the natural gas futures market was in contango at that time.

The NYMEX natural gas futures reflect the spot prices for natural gas scheduled to be delivered at Henry Hub, Louisiana, where 16 intra- and interstate natural gas pipeline systems meet. NYMEX Henry Hub prices are generally considered the domestic natural gas benchmark. To avoid taking actual physical delivery of natural gas, the fund rolls its contracts over before they're set to expire. The fund typically rolls over near-month contracts to the next month's contract. However, there's frequent price fluctuation in natural gas futures contracts for the two weeks or so before they expire. In these cases, the fund invests in the subsequent month's contracts rather than the near-month one. This can negatively impact the fund's tracking error to the NYMEX benchmark. While the fund primarily invests in futures, it also reserves the right to purchase forwards, swaps, and spot contracts (selling before it expires to avoid physical delivery), as well as some overseas contracts. And, while it mostly invests in U.S. contracts, it also reserves the right to buy some contracts on the ICE Futures market.

Like other commodity futures funds, this fund also is subject to the effects of contango and backwardation. Contango is when you pay more for delivery dates that are further off and backwardation is when you pay less for delivery dates further off. When contango or backwardation occurs, an investor in the fund won't necessarily get the return that spot prices for immediate delivery would yield, because the futures prices are bid up or down in advance.

		ETFInvestor Newsletter
	Let our new newsletter, Morningstar ETFInvestor, help you navigate the exciting and new world of exchange-traded funds. Each issue includes recommendations for commonsense ETF investing,		ETF spotlights, and critical data on 150 top ETFs. This one-year subscription consists of 12 monthly issues. Learn more.
	$159.00 for 12 Print Issues		$149 for 12 PDF Issues

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.