ETFs/ETNs Becoming Hybrid Closed-End Funds (USO, UNG, DBO, DXO, GAZ, GSG, GS, MS, GLD, SLV, JJC, FAS, FAZ)

Two months ago it was a carnal sin to suggest that certain exchange-traded funds or notes which track commodities would start trading more like a closed-end fund based upon supply and demand moves in shares caused by in-flows and out-flows of orders rather than solely by the direction of the prices of underlying commodities.  It has been our ongoing prediction that many commodity ETF/ETN products (and maybe some leveraged products as well) will become more like closed-end funds. Yet here under new regulations that have not even become gospel, we have seen new share issuances either denied or withdrawn from some of these ETF or ETN products.  And we are getting to see a premium in pricing to boot.  The United States Natural Gas Fund LP (NYSE: UNG) is the most classic example out there.  This ETN was at a 15% to 16% premium to the actual gas futures as investors are choosing to pay higher prices just for the ability to get exposure in the portfolio in case these prices rise.  The UNG has already confirmed that no new shares would be issued currently, and it is now so large that it controls closed to 20% of the benchmark natural gas contracts.  Limitations of this sort will drive a free-market theorist nuts, but the other reality is that this can also create large directional price moves that have nothing at all to do with fundamentals.

It turns out that the PowerShares DB Oil Fund (NYSE: DBO) traded about 0.3% higher than its actual value in crude futures late last week, and limits to shares could exaggerate premiums and discounts.  And the PowerShares DB Crude Oil Double Long Exchange-Trade Note (NYSE: DXO) has also suspended issuing new shares. Barclays has also said that it would, at least temporarily, suspend new shares from being issued in its natural gas ETN called the iPath Dow Jones-AIG Natural Gas Subindex Total Return Exchange-Traded Notes (NYSE: GAZ).

Barclays also said that it would stop issuing new shares of the iShares S&P GSCI Commodity Index Trust (NYSE: GSG) once the outstanding amount reached 55.9 million shares. If our data is accurate on the latest count, that looks to stand at roughly 52 million shares.  This is a semi-diversified product that tracks about 24 different commodities in energy, agriculture, industrial metals, prcious metals and livestock.  It is energy dominant, but this was a much more diversified fund that decided to limit its size.  This one also has traded at a premium to its underlying value.

It is unlikely that either Goldman Sachs Group (NYSE: GS) nor Morgan Stanley (NYSE: MS) will get to escape with total exemptions on limits to the size of the markets despite the notion that these are two of the largest players in the commodities trading space.  In the past, it has not been uncommon for those traders who trade futures to suddenly have the NYMEX or other exchanges suddenly impose higher margin requirements just to trade or hold positions in futures in commodities.  The underlying theme there is that you might not be able to stop speculation, but you can drive up the costs of playing poker for the same results.

There is a key takeaway for investors to consider here.  The “GLD” or the SPDR Gold Shares (NYSE: GLD) is probably not going to be immune to this trend of limiting the size or scope of speculative investment limits in the commodities markets.   The market cap of the “GLD” is over $33 billion and that is effectively just about all in direct holdings of gold bullion.  Should an ETF product have more gold than all but a handful of the world’s largest central banks?  Our belief is that this will be next on the list after the CFTC and regulatory bodies get limits on these energy contracts.

Ditto for the iShares Silver Trust (NYSE: SLV) with about $3.9 billion in assets and the iPath DJ AIG Copper TR Sub-Idx ETN (NYSE: JJC). These are not as much of leaders as some of the other ETF or ETN products out there, but the rules will probably be extended out to these next year.  Could you imagine the disparity between inflation of commodities if you had a market where speculation size limits were imposed in the energy markets but not in the prices of metals and other hard commodities?  Many of the soft commodities have had size limits imposed for years because of the size of the overall markets.

Many of these key ETF and ETN products are already starting to resemble closed-ends funds.  While the financial stocks are not at all related to size limits of commodity ETF or ETN products, many leveraged an inverse stock ETF products have been under regulatory pressure.  Look at what Direxion said about its highly-leveraged financial ETFs called the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and Direxion Daily Financial Bear 3X Shares (NYSE: FAZ).  This fund management group has been ahead of the curve by saying that these should not be held for the long-term and showed how the underlying index performance differed from the spot performance of those ETFs.

What many will want to know is if tulip contracts will be issued soon, and more importantly if there are going to be size limits on those.  After all, that is the most classic case of speculators driving prices above and beyond the reality of a fair market rate in history.  All joking aside, the size limits to some of these products will be here for a while.  It is also unlikely, although not definite, that investors will get a wave of newer competing ETF and ETN products that can compete against those already in existence.  Any time you see an ETF or ETN that has a fixed number of shares that cannot grow and any time these have a  real premium or discount to the net asset value that is beyond just a few snapshots due to market volatility and an inability for all prices to react simultaneously, then you are talking about closed-end funds.

This trend is not likely to be referred to in the history books as the “blip of time in 2009 where commodity ETF’s were capped.”  Speculators will still get to speculate.  But the price of poker will be higher.  This might even sound so late-Twentieth century, but most investors might even have to go back into investing in the stocks of the companies that actually are the real market participants in each commodity.

JON C. OGG
August 24, 2009