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Challenges Loom for Commodity Mutual Funds

Our thoughts on possible new regulation on the commodity futures front.

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You may not consider yourself a "speculator," but you might be affected by new regulation in the commodity futures market aimed at curbing excess speculation. The explosive growth in commodity investing in this decade among institutional and individual investors alike has coincided with rapid rise in commodity prices. (We're a ways off the mid-2008 peak, but prices remain high compared with 10 years ago.) Regulators have drawn a link between the two trends. Thus, the Commodity Futures Trading Commission is widely anticipated to come out with new regulation that would impose limits on futures activity by traders who are not direct commodity producers or consumers. Such restrictions on "speculative" investors would likely affect commodities exchange-traded funds and mutual funds.

What We've Seen So Far
The threat that the CFTC would impose strict ceilings on how many futures contracts traders or investment vehicles can hold has already had some serious consequences in the world of exchange-traded investments. In July,  United States Natural Gas (UNG) stopped issuing new shares. And PowerShares DB Crude Oil Double Long ETN was liquidated early in September, as Deutsche Bank decided to no longer write the notes through which the fund derived its return. It is likely that Deutsche Bank needed to preserve capacity in other parts of its commodity business in the face of stricter futures position limits. You can read more about these developments here.

By contrast, none of the small group of commodity traditional mutual funds has so far shown any signs of disruption in day-to-day activity. Even  PIMCO Commodity RealReturn Strategy (PCRDX), the undisputed behemoth of the group with assets close to $12 billion, is operating normally and remains open. Still, it's easy to imagine scenarios in which the mutual funds would be facing the same capacity constraints as the exchange-traded products cited above. These funds get their exposure to the commodity index of their choice through swaps, structured notes and other over-the-counter derivatives. Their counterparties are usually big banks like Deutsche, who must buy a proportionate number of futures contracts in order to write the swaps or notes. These dealer banks may not be able to service their mutual fund clients if the position limits become binding. Before we talk more possible outcomes for commodity mutual funds, however, let's dig a bit deeper into the question of excess speculation itself.

Arijit Dutta does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.