New Challenges for Commodity ETFs

A lot has happened in the world of commodity ETFs, even since I wrote my last article earlier this week. As if returns-crushing contango was not enough to deal with, regulator concerns about the size of several commodity ETFs and ETNs have led to issuers halting creation of shares or selling holdings, increasing tracking error and creating premiums. Legislators began putting the Commodities Futures Trading Commission under pressure to investigate commodity ETFs as early mid-2008, when the House of Representatives passed the Energy Markets Emergency Act of 2008 in response to rising energy prices. As commodity prices plummeted in the second half of 2008, so did Congress' interest. However, both are on the rise once again.

Grains Indexes Come Under Fire
The Senate Permanent Subcommittee on Investigations released a mighty tome of a report on wheat futures on June 24, 2009, entitled "Excessive Speculation in the Wheat Market". The subcommittee came to the conclusion that long positions held in the wheat futures market by commodity index trackers had caused rising prices, undue volatility, and a persistent failure for futures prices to converge with the cash market prices for actual wheat.

Whether these charges are accurate is an argument for another article, but pressure from this report resulted in the CFTC revoking on August 19 position limit exemptions for two PowerShares ETFs tracking Deutsche Bank commodity indexes.  PowerShares DB Agriculture (DBA) and  PowerShares DB Commodity Index (DBC) have to withdraw some of their positions from the wheat, corn, and soybean markets on the Chicago Board of Trade. The portfolio managers have found substitutes in similar contracts trading on the Minneapolis Grain Exchange and Kansas City Board of Trade, but slight differences between the contracts will lead to some tracking error in the portfolios. Also, these secondary commodities markets have much less trading volume and open interest than the CBOT, so they will provide little room for these funds to grow further without bumping into position limits once again. Ultimately, these funds may have to resort to overseas markets not covered by the CFTC or off-exchange swap contracts that expose the funds to counterparty risk.

What's Happening to Energy
Investors who followed the dramatic growth of  United States Oil  (USO) at the end of 2008 and beginning of 2009 probably remember how it took up a vast share of the U.S. oil futures market on the New York Mercantile Exchange, or NYMEX. Without CFTC scrutiny, the fund never had to stop issuing shares, but it did produce tremendous distortions in the market as other traders front-ran its massive trades and prevented it from benefiting as the spot oil price began to rise. As assets fell, so did the contango produced by the USO's holdings, and the fund finally began to move with the oil prices.

The bigger and badder sequel to USO began in the Spring of 2009 as money flooded into  United States Natural Gas (UNG). Compared with crude oil, which has one of the largest and most liquid commodity futures markets in the world, natural gas is a sleepy corner of the market. Assets in UNG swelled to more than $4 billion by July 2009, by which point the fund held nearly every long position in the front-month contract of the NYMEX natural gas contract, as well as huge positions in the equivalent contract on the London-based Intercontinental Exchange, and substantial swap contracts with major broker-dealers. UNG was not the 800-pound gorilla of the natural gas market--it was King Kong.

Regulators did not step in as UNG continued to grow and its price continued to shrink. The SEC simply refused to approve more shares once the fund ran into its preapproved limits from its latest prospectus (a situation that has since changed). As UNG stopped issuing shares, we saw money start to pour into the similar iPath DJ-UBS Natural Gas Total Return Sub-Index ETN   (though this fund is not an exact substitute for UNG, as it tracks a different contract one month further out on the futures curve). However, concerns about regulatory action seem much higher nowadays.  PowerShares DB Crude Oil Double Long ETN  stopped issuing new shares on August 18 at an effective position size of $960 million (double its actual assets to adjust for leverage). Just this morning, Barclays halted issuing new shares of GAZ.

This new development is surprising for a number of reasons. While the PowerShares funds held more than $3 billion across their three grains positions and United States Natural Gas still has more than $3 billion in assets, GAZ has only $190 million in assets. Furthermore, GAZ is an ETN. As such, the backing bank Barclays has more flexibility to hedge GAZ using multiple natural gas contracts with different expiry dates, allowing it to avoid the most restrictive single-contract position limits. (This also applies to DXO, but we go into the potential reasons for their lack of issuance at the end of this article.) Barclays may have needed to clamp down on GAZ's growth to prevent its hedging positions from interfering with their own proprietary trades in natural gas, which would be problematic for regulators who want to distinguish bank trading desk commodity positions from futures positions held for major clients. Whatever the ultimate reason, the small size of this newly closed fund shows the depth of concern about the CFTC and the potential shape of new regulation on commodity futures markets.

 

How You Can Avoid the Squeeze
The CFTC has not revealed much about the position limits they plan on imposing, which heightens the current caution of most commodity ETF and ETN issuers. However, we can identify those attributes which make funds more likely to run into trouble with regulators in the near future. If you plan on investing in a commodity fund, or already hold some in your portfolio, please check for the following warning signs.

1) Does the fund invest in futures or the physical commodity?
The largest commodity ETFs today are still the physical commodity ETFs such as  SPDR Gold Shares (GLD) and  iShares Silver Trust (SLV) that hold stakes in actual bars of precious metals. Because these funds do not invest in futures, they will not run into problems with the CFTC no matter how large they get.

2) Does the fund invest only in a couple commodities?
Unsurprisingly, the funds which ran into the largest problems thus far are the funds that concentrate in only one or a couple commodities. Because these ETFs and ETNs cover only a few possible futures contracts, they quickly distort the market as they grow larger, encouraging other market participants to trade around their holdings and detracting from returns. Diversified funds such as  iPath Dow Jones-AIG Commodity ETN (DJP) will take much longer to run into position limits or market-distorting sizes of holdings, because each dollar invested in DJP invests only 17 cents in crude oil, 11 cents in copper, and less in each of the other 17 commodities it holds.

3) Is the fund particularly large, or does the family offer other large funds that invest in the same commodities?
PowerShares DB Commodity Index ETF grew quite large as investors concerned about the credit risk of ETNs moved money into this diversified alternative. However, few investors looked at the underlying portfolio holdings and realized that its 22%-23% stake in corn and wheat represented a high concentration in these two medium-sized markets. Even fewer considered that PowerShares DB Agriculture invested the vast majority of its $2 billion assets in the same wheat and corn contracts along with a hefty soybeans stake. Still, the holdings of both PowerShares funds were managed by the same group at DB Commodity Services LLC, and thus both funds came under fire at the same time for the combined sizes of their grain futures holdings.

4) Does the fund invest in only one contract expiration per commodity?
Current regulations tend to include a limit on the number of contracts held on a given commodity that expire in a given month, and a higher limit for the total number of contracts held across all futures expiration dates in that commodity. Currently, nearly every commodity index tracks a specific contract for each commodity, resulting in unnecessary concentration of index investments. The UBS-Bloomberg Constant Maturity Commodity Indexes avoids this issue and mitigates losses to contango by holding multiple contracts in each commodity to keep a fairly constant position on the futures curve and minimize the effects of roll yield. We expect in the future that more commodity indexes will track multiple contracts to spread their tracking investments across futures maturities and avoid the more restrictive single-contract limits.

Which ETFs or ETNs Are Next?
The funds already afflicted include the three largest commodity futures ETFs today. These were the top suspects, and the next one to fall is far from certain. But here are some of the top possibilities.

United States Oil 
This ETF still has more than $2 billion in assets, which would represent 11% of the open interest in the NYMEX crude oil October 2009 contracts. A similar size position would not be allowed in grains futures, but energy commodities currently lack hard-and-fast position limits. If the CFTC imposes position limits, this fund may fall afoul of the new regulations.

PowerShares DB Energy (DBE),  PowerShares DB Oil (DBO), PowerShares DB Crude Oil Long ETN (OLO)
The PowerShares DB lineup of commodities ETFs has succeeded in pulling in plenty of assets, but they do not tend to have the diversification of the iPath broad commodity funds. Between DBC, DBE, and DBO, the PowerShares DB ETFs have $1.7 billion invested in a single expiration date of light crude oil futures. If we include their leveraged ETNs, also backed by Deutsche Bank and based upon the same roll-optimizing index, the total rises to nearly $2.7 billion. Their double-long ETN (DXO) has already stopped issuing new shares effective August 18, so we would not be surprised if troubles for these other funds were not far behind.

 iPath Dow Jones-UBS Commodity Index ETN (DJP)
This ETN holds a diversified basket of commodities, but its natural gas stake of 6.3% would work out to $90 million at today's asset levels. If assets returned to their mid-2008 highs, this ETF would have as large a stake in natural gas as GAZ when it halted new share creation. While not an imminent threat, this is worth considering as Barclays also runs a large ETF and ETN tracking the S&P GSCI index (which includes a smaller 3.8% stake in natural gas).

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