Commodity ETFs' Future Under A Cloud

• Trang Ho
• On 6:47 pm EDT, Monday September 14, 2009

ETF providers usually ax ETFs because of low demand. But Deutsche Bank has killed a successful exchange traded note, PowerShares DB Crude Oil Double Long ETN (NYSEArca:DXO - News), not due to lack of popularity but because of new exchange rules. The note, which doubled the return of oil, ceased trading on Sept. 9.

Matt Hougan, managing director of ETF Analytics at IndexUniverse.com, explains what happened and what it means for other commodity-linked exchange traded products. At the center of the issue is the size of positions ETF firms amass in futures contracts in order to hedge the opposite positions they take when they sell their products to ETF investors.

IBD: Why did Deutsche Bank shut down DXO? With $450 million in assets, it was a hit.

Hougan: No one is saying for sure. But if you read between the lines, it appears that Nymex cracked down on the fund. Basically, Nymex told Deutsche Bank that it had accumulated too big a position in the contract that DXO tracked -- the July 2010 WTI Crude Oil futures contract. Deutsche had to reduce that position. Not many people know it, but exchanges have the power to enforce position limits in all commodities. They haven't used that power much in the past. But with all the regulatory scrutiny surrounding commodity ETFs these days, they've started to change their tune.

IBD: But ETNs are debt notes that don't actually hold the underlying asset. Why would new exchange rules affect them?

Hougan: Because the position had to be hedged. Deutsche Bank isn't interested in having open short exposure to the crude market. It's interested in making money by offering a note and charging investors a management fee. So while the ETN itself doesn't own crude oil futures, Deutsche Bank needed to find a way to hedge its position. It did that by buying the relevant futures contracts.

IBD: Why did Nymex start imposing position limits? What's the upshot of these new rules on commodities trading?

Hougan: That's a good question. I think the answer is (Commodity Futures Trading Commission) Chairman Gary Gensler. Gensler has been very aggressive about pressuring the exchanges to use their position to limit powers. In July, he directly criticized the exchanges for failing to do so in public, written testimony. It looks like they hear him loud and clear.

Gensler doesn't really see a role for index investors in the commodities market. Most people expect the CFTC to announce new position limits on energy commodities in October that will seriously impact the ETF space. I think those limits will be harsh and there will be few exemptions for so-called "speculators" like ETFs.

IBD: Could Deutsche Bank hedge the note some other way? Why aren't those options feasible?

Hougan: Yes, it could have done a lot of things. It could have spread its hedging bets across multiple contract months, rather than focusing on the single month that DXO tracked. It could have bought Brent crude contracts to supplement its WTI exposure. It could have bought WTI futures on another exchange, such as ICE. Or it could have bought swap agreements from third parties.

The first three options weren't feasible because DXO is an ETN. ETNs guarantee investors perfect tracking against a benchmark. Had Deutsche Bank bought, say, both June 2010 and July 2010 contracts, even that small deviation from the index (which tracks on July 2010 contracts) would have put too much money at risk. Remember, DB was only charging 0.75% in annual expenses for the note.

Private swap contracts should have been an option. But because of all the regulatory scrutiny, commodity swap contracts are getting increasingly expensive. And DXO was a leveraged fund: It needed 200% swap exposure, despite charging the same expense ratio as nonleveraged commodity funds.

It probably wasn't worth the money to run DXO with private swaps in the current market.

IBD: What are the implications for other commodity ETFs and ETNs?

Hougan: I think this is the tip of the iceberg. I think we'll see more funds and notes run into trouble due to exchange-driven position limits. More importantly, I think we'll soon see federal limits from the CFTC. The end result is that commodity ETFs and ETNs will become more expensive and less transparent, and will do a worse job tracking their benchmarks. I don't think Gensler will succeed in eliminating them from the market, but I do think he will make it hard for them to thrive.

Buzz up!