MarketDNA Blog September 3rd, 2009

The telegraphed day of reckoning has finally arrived and many commodity ETFs (ETNs) are now finding themselves in the regulatory line of fire.

I have been on the record with my MBA students and with many of my colleagues in the investment business for quite some time on the multitude of problems associated with commodity ETFs and now it seems corrective actions are being taken.

Just recently UNG, the ETF which attempts to track nat gas futures performance, was subject to massive price distortions. UNG built a premium in its price versus its NAV of as much as 20% due large inflows of money; these inflows reflected investors’ bottom fishing but UNG was suddenly unable to expand its position due to an abrupt fear of breaching position limits in the futures pit. When an ETF cannot deliver on its strategy for regulatory fear, the model is pretty much broken.

Along the same lines, today we hear Deutsche Bank will close down its leverage long oil ETF due to similar concerns. D Bank is not having a very good streak as its agricultural commodity ETF was also stripped of its exemption on speculative limits in the correspondent futures markets and therefore will find it more arduous to continue with the same business model.

Since their inception, I have been a great advocate of ETFs in general but commodity ETF specifically were always ridden with issues. From a regulatory point of view, these were hybrid products, which were backed by derivatives and yet traded like securities avoiding proper scrutiny. By using futures to manufacture tracking performance for the equity investor, they were also inherently leveraged bypassing leverage restrictions normally applied to equity products (this is an issue with index ETFs as well and not only with commodity related products).

Commodity ETFs, furthermore were practically built on the wrong assumption of permanently long only products with obvious price distortion ramifications in markets like commodities built for hedging purposes. Commodities have really no beta because they are consumable, transformable and perishable asset. Frankly, I am beginning to think that the concept of beta is one massively flawed idea in every market…but this is material for another blog. The idea that equity investors should passively include this asset class indiscriminately in their portfolios was another one of those brilliant, self-serving ideas of Wall Street – always driven by the never ending search for a way to needlessly repackage risk and earn fees. If an equity investor feels the need to incorporate inflation hedging in his/her portfolio or seeks an edge in overweighting the commodity sector, there are already plenty of proper choices: TIPS, Commodity Stocks, Gold etc.

Commodity trading is just that: trading, exploitation of anomalies, price arbitrage and it should be approached in that way. Futures traders, CTAs, hedgers are the natural players in this game; ETFs…not so much.

From a strategic perspective, it is reasonable to expect a potential dull period in commodities as these ETFs may be forced to close or downsize for quite some time.

Welcome to a New Normal in commodities as well?