A balancing act for commodity ETFs

With commodity position limits being strongly enforced, ETF analyst Bradley Kay thinks that investors in commodity ETFs should shy away from larger funds and look to smaller, nimbler ones.

Below is the full transcript.

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. Commodity Exchange Traded Funds, or ETFs, have been in the news recently as the Senate has pointed out that they think some of these long-only indexed commodity ETFs could be responsible for some manipulation in the futures markets of several commodities. Here to discuss this with me is ETF analyst Bradley Kay. Thanks me for joining me, Bradley.

Bradley Kay: Always a pleasure.

Glaser: Do you think it's possible that some of these commodity ETFs have been responsible for some manipulation or some mispricings in futures markets?

Kay: I'd say that they've certainly changed some of the pricing in the futures markets. I wouldn't go outright to call them manipulation. In fact, to some extent I feel that part of the problem for typical investors is that largest of these funds are themselves getting manipulated. Indexes by their nature have to be very transparent. You have to know where they're trading, when they're trading. And the problem is, is that that can get taken advantage of by other market participants.

Generally this doesn't matter very much, and you see it in, say, the S&P 500 where funds will try and buy into a stock before the S&P 500 does. But it's only a few percentage points, because the equity market is very deep, and it only covers a very small holding of the fund.

In the case of futures funds, they're rolling over their entire holdings when they change between contracts. And it's a much less liquid market, so you can actually end up with other participants taking their positions, taking the index positions, before the index does, and causing them to take poor prices.

This is part of the reason I think that I think we're seeing such steep contango, which has actually hurt the returns on a lot of these funds lately. So it is definitely distorting the prices, but I wouldn't say that it's manipulating the prices in the case of the indexes.

Glaser: So would you say that then it's not that the ETFs are necessarily causing the price of oil to be higher for consumers, or causing the prices of wheat, but having a futures curve that might not reflect what people are actually willing to pay in the future, is that hurting some producers or some suppliers?

Kay: Exactly. To producers, actually, this is a great help. There's a large long-only pressure trying to buy these contracts, which actually means for producers it's great. They can lock in their future production at relatively high prices they can sell. It somewhat hurts the major firms which try and hedge their future consumption. The best example is, say, processed food companies, who try and hedge their wheat consumption or their corn consumption.

But in the case of a lot of energy markets actually, this is going to help the guys who are trying to sell their future natural gas, trying to sell their future oil, before they even produce it.

Glaser: So with all of this talk about there maybe being distortions, there's talk about extra regulations, more regulations of these ETFs. What do you think are some of the most probable regulations that could be enacted and what would the impact of those be on an individual investor?

Kay: What we've seen right now actually are fierce position limits being put into place. Or at least finally being very strongly enforced. And so this has actually come about. We're already seen some funds close. The United States Natural Gas Fund has closed, was finally allowed to reissue shares, but has decided to remain closed. Another fund from iPath which covers natural gas has also closed. And so it seems that they are really imposing fairly strong restrictions on the amount of positions that any of these funds can hold in any given commodity. And the more important issue is that they are exercising it across an entire family.

And so for example, the iPath fund which was forced to close is very tiny on its own, but the key is that it's part of a very large family run by Barclays, which also has several index funds with large positions in natural gas. So that's what's important, is that you will see not just the size of your fund that matters as to whether you could face closure in the future, but also the size of the family that you're investing in begins to matter a lot.

Glaser: So are there any fund that you think would be a good choice for investors right now, looking for exposure?

Kay: One of he funds that we still like, which is still quite a modest size is the Elements S&P CTI ETN, and that is ticker LSC. The nice thing about that as well is that it can take short positions, so if we actually do run into a period where there is a lot of commodity indexes buying in and futures prices remain permanently high, that is going to hurt all of these indexes because they will constantly be buying at a high price in the future and selling at a low price as it moves towards expiration. LSC can actually take the opposite side of that bet and sell at the high price and then buy back at the low price later, shorting the futures. So that's something that we definitely like.

Otherwise we have also seen some start to move into Rogers International Commodity Indexes. So the big fund tracking that is an ETN, Elements Rogers International Commodity Index, RJI is the ticker.

Glaser: So in general there's going to be some changes in the commodity ETF marketplace, so when people are looking they should be cognizant of this. Maybe look for a mid-sized fund instead of looking at one of the bigger families. And they should certainly be aware that changes are coming down the pike.

Kay: Exactly. You want enough assets to know that you can buy in at a fair price, and that there's enough trading volume you can actually get your position. But you are going to face a very real risk of running into position limits and fund closure if you want to invest in the very biggest. So it's a bit difficult; everything's been changing a lot over the past week or two. But we're hoping that over the next few weeks, over the next couple of months, we'll get a little more clarity.

Glaser: Thanks for talking with me, Bradley.

Kay: Thank you.

Glaser: I'm Jeremy Glaser with Morningstar.com. Thanks for watching.