Challenges Loom for Commodity Mutual Funds

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 , 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.

The Case for New Regulation
There is still a lot of debate about precisely what's really so problematic about commodity markets and if position limits on certain types of traders can make markets function better. In the big scheme of things, market movements still make sense. Commodity prices did tumble in the second half of 2008 when it became clear that demand would be sharply lower due to the slumping global economy. And despite the large number of futures contracts bought by ETFs and other financial investors, natural gas prices are low.

These examples suggest that good old supply and demand can explain much of the sharp price moves we've seen in recent years. True, the massive influx of commodity investors in recent years could have caused the persistent contango we've often seen in many commodities. (Contango is the state in which futures prices are higher than spot prices and the further-dated futures contracts are trading higher than near-dated ones for any commodity.) If everybody piles on the long side of the trade, futures prices will conceivably get pushed higher. But even this is not a settled argument because many still believe inventory conditions play a bigger role in causing contango. For example, excess supply of a commodity (natural gas, as a current example) causes lower prices as well as lack of storage space, which produces contango as a way of rewarding those who can still store the commodity for future delivery. In short, this is again about basic supply and demand rather than about hordes of speculators causing trouble.

It's also worth noting that these supply-demand imbalances can correct themselves in time. For example, contango in natural gas futures means higher prices along the futures curve, so fund investors are getting fewer contracts for their dollar when their existing contracts are rolled over. This will naturally lead to financial investors holding fewer contracts, even without any regulatory limits on how many contracts they can hold.

Yet another important distinction to make is between hyperactive speculators at proprietary bank trading desks, hedge-funds, or even among commodity producers and consumers on one side, and mostly buy-and-hold investors at mutual funds. Funds that track a diversified basket of commodities are still less likely to be vehicle of choice for highly speculative market-timing activity.

What Should a Commodity Fund Investor Do?
Despite the above arguments, lawmakers and regulators may still make a case for imposing stricter position limits in the interest of preventing market concentration. After all, there have always been limits on the number of contracts in a given commodity a single trader can hold. New regulation would, for the most part, tighten the current exemptions to those limits. Should shareholders at commodity mutual funds be concerned that these investment vehicles won't remain viable under such restrictions?

There is a lot of uncertainty at this time about what exactly the CFTC will propose, but we think shareholders should stay put for now. There is a decent chance the CFTC will come up with a solution that is not onerous for mutual fund investors. The regulator's research has not found evidence that speculators or financial investors have distorted prices or led them higher. (It is still in the process of releasing fresh data that could bring more clarity to the debate.) Indeed, CFTC's data supports the contrary argument that financial investors provide the liquidity needed to offset the imbalance that can often occur between the hedging needs of commodity producers and consumers. Thus, there is reason to believe new regulation may temper financial investors but not prohibit them. Commodity mutual funds are mostly passive, diversified long-only vehicles, which does not fit the profile of all-out speculators. Thus, any new regulation could well be mindful of the interest of common investors looking to reap the diversification and inflation-fighting characteristics of commodities.

Also, commodities mutual funds are no stranger to regulatory hurdles. In 2005, the funds were able to successfully retool after the IRS deemed interest income from certain derivatives would no longer get the beneficial tax treatment accorded to mutual funds. It's reasonable to hope the regulators will once again allow the mutual funds to operate within a somewhat changed set of rules. We are somewhat concerned about the possible impact on fund expenses though. If the banks have fewer futures contracts available, it is foreseeable that swap costs will rise.