Rules Could Put Squeeze On Retail Investors In Commodity ETFs

News Date: 10/05/2009 Outlet: Dow Jones Newswires Contact: Baskin, Brian

By Brian Baskin
Time: 17:39

NEW YORK (Dow Jones)--Washington regulators have begun targeting the big-time speculators whom they suspect of artificially inflating prices for oil, natural gas and gold. Turns out some of the big guys happen to be small fry.

Exchange-traded funds, which have become popular as one of the few avenues for small investors to gain direct exposure to commodity futures, are a top target in the U.S. Commodity Futures Trading Commission's drive to rein in speculation in oil markets. The CFTC's moves reverse a trend in market innovation that allowed almost anyone to bet on the direction of energy prices along with the likes of large companies such as Goldman Sachs Group Inc. (GS).

And bet they did. Commodity ETFs came into existence in 2003 just as the boom in commodities prices was getting underway. They have ballooned to hold $59.3 billion in assets as of July, according to the National Stock Exchange. Since the beginning of the year, $22.1 billion has flowed into these funds compared with inflows of $7.3 billion during the same period in 2008. Almost half of the new money coming in this year is directed at the largest commodity ETF, which buys gold, due to widespread worries about inflation.

The funds pool money from investors to make one-way bets, usually on rising prices. Some say this creates runaway buying momentum that ignores bearish signs that more knowledgeable investors and commercial hedgers usually heed. The CFTC has said its priority is to protect end consumers of commodities, who would benefit from lower prices that regulators and lawmakers say would result from limits on speculation.

Cutting out retail investors isn't the goal, said Bart Chilton, a CFTC commissioner, in an email.

"The Commission has never said 'You aren't tall enough to ride'," Chilton said. "I don't want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation - intentional or otherwise."

Small Investor's Plight

Yet the regulatory changes are already reshaping this popular corner of the investing world for small investors.

Limiting the size of ETFs will result in higher costs for investors, who range from individuals to banks and hedge funds with multimillion-dollar positions, because legal and operational costs have to be spread out over a fewer number of shares. It would also render the instruments less desirable, because prices of the shares of closed funds tend to deviate from price moves in the underlying commodity.

Already, United States Natural Gas Fund LP (UNG), or UNG, is trading at a 16% premium to gas futures because investors are willing to pay extra for the ability to expose their portfolios to the commodity. The PowerShares DB Oil Fund (DBO), which tracks crude futures with no share limit, traded 0.3% above its benchmark commodity Thursday.

Last week, UNG confirmed it wouldn't issue more new shares and said it owns about a fifth of certain benchmark gas contracts, potentially higher than the new limits will allow. Deutsche Bank AG's (DB) PowerShares DB Crude Oil Double Long ETN, an ETF-like security similar to a bond, followed suit on Tuesday. The CFTC said Wednesday it withdrew exemptions it had granted two Deutsche Bank commodity ETFs years ago on speculative limits on corn and wheat contracts. On Friday, Barclays Bank PLC (BCS) said it would temporarily suspend any new share issues for its natural gas ETN.

"What you're really saying is the only people who should be allowed to trade crude oil are oil companies and Morgan Stanley," John Hyland, chief investment officer for the company that manages UNG and the largest crude oil ETF, told CFTC commissioners in a hearing earlier this month. He defended his funds as existing "to serve people who otherwise would find it difficult or undesirable to themselves buy futures."

Goldman Sachs and Morgan Stanley (MS) are two of the banks considered to be the most active in commodities trading. They also are likely to feel the impact from the new rules.

Hyland claims between 500,000 and 600,000 investors in his United States Oil Fund LP and UNG, both of which have come under scrutiny due to their sheer size.

Vernon Reaser, a small business owner in Houston, is one of those investors and he said he is frustrated that regulators' actions are essentially discouraging him from accessing commodities markets.

"I'm American and am all for stability," said 43-year-old Reaser. While small investors tend to shy away from futures due to high costs and margin requirements, without ETFs, "there's nothing left but futures," Reaser said.

Smaller funds could spring up to take in investors prevented from joining funds that run afoul of federal limits, but at a price.

"If they give up on scale and have to drive their expense ratios up...that just makes it a higher bar for the fund to jump to generate positive returns," said Mark Willoughby, a financial adviser with Modera Wealth Management in Old Tappan, N.J.

Willoughby recommends that most clients invest 4% to 7% of their holdings in commodities, but said his firm is debating the best ways to do so in light of recent developments.

Investors shut out of ETFs would still have a few ways to track commodity prices, such as investing in a major oil company like Exxon Mobil Corp. (XOM). Their shares usually, but not always, move with energy prices.

-By Brian Baskin, Dow Jones Newswires; 212-416-2453; brian.baskin@dowjones.com

(Ian Salisbury and Anna Raff contributed to this report.) [ 08-21-09 1739ET ]

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