Exchange Traded Funds are useful instruments that can do wonders for your portfolio. ETFs can lower your expense costs, reduce diversification risk and allow you to access previously inaccessible markets. They can even lower your taxes when compared to mutual funds.
But one thing ETFs can't seem to do is track energy prices. ETFs that invest in energy futures have had a terrible time this year as a market condition known as contango has eaten away their returns. The United States Oil Fund (NYSEARCA:USO) is up 16% ytd, while crude oil itself is up over 50%. This massive underperformance is no secret and no fluke; it's the inevitable result of the investment strategy listed in USO's prospectus. But many investors who thought they were buying a fund that tracked crude oil have been burned.
Now with natural gas prices set to rise, investors are rushing into the USO's sister fund - the United States Natural Gas Fund (NYSEARCA:UNG). But the UNG seems to have even more problems tracking the price of its target commodity. Meanwhile, concern is growing that both funds now have undue influence on their markets and they could face regulatory pressure in the future.
Although ETFs which invest in futures can be useful, a safer and potentially more lucrative strategy exists: investing in a broadly diversified ETF which holds shares in commodity producers. For natural gas the relevant fund is the First Trust ISE/Revere Natural Gas Index Fund (NYSEARCA:FCG).
This fund has stakes in major natural gas names like Devon Energy (NYSE:DVN), Quicksilver Resources (NYSE:KWK), and Newfield Exploration (NYSE:NFX). It's up 22% this year, while the UNG is down 33%. It carries an identical .60% expense ratio, and isn't affected by problems in the futures market. Although the FCG is thinly traded, it shouldn't be. Natural gas prices are well below their historical average, and the FCG is trading at barely 7 times earnings.