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The recent controversy surrounding futures-based commodity ETFs has left the PowerShares DB Oil ETF (NYSEARCA:DBO) noticeably unscathed. DBO, which tracks the futures contracts of Light Sweet Crude, has gained momentum in recent weeks, moving from the no. 90 spot in our ETF Sector Momentum rankings on May 19 to the no. 36 position on August 11. As the regulatory spotlight falls upon these futures-based funds, DBO may be in a better position to survive the scrutiny than peers like the United States Oil ETF (NYSEARCA:USO).

Both DBO and USO offer investors exposure to the performance of oil spot prices by tracking a basket of futures contracts. This strategy is particularly compatible with the ETF structure, and would be very difficult for an individual to achieve through a series of contract purchases. This accessibility has made funds like DBO, USO and United States Natural Gas (NYSEARCA:UNG) particularly appealing to investors.

Complications have plagued the success of these futures-based commodity ETFs. Since the funds track futures contracts, which expire, fund managers must “roll forward” the underlying basket each month to continue the investment. This process can have two outcomes: contango and backwardation. As the funds buy the next series of contracts, there is a disconnect between the underlying value of the fund and the funds market price. This difference can result in underperformance for investors.

While USO investors are particularly vulnerable to the disadvantages of this “roll” process, DBO rolls its futures contracts in a manner which is aimed at potentially maximizing the roll benefits in oil markets that are in backwardation and potentially minimizing the losses from rolling when markets are in contango. Rather than just rolling into the next month, DBO rolls into the futures contract with a delivery month within the next 13 months that generates the best possible roll yield. If two futures contracts have the same implied roll yield, the futures contract with the minimum number of months prior to the delivery month is selected.

The second problem facing futures-based commodity funds like DBO and USO is potential regulation. The Commodities Futures Trading Commission is currently examining the role that indexing strategies, like ETFs, have in impacting commodities prices. The CFTC is examining the possible implementation of position limits that would impact the growth of many commodities funds.

Merely the speculation about regulation has already caused a major disruption in UNG. When the fund “ran out” of its pre-allotted shares in July, creation was halted. Creation is the process through which ETFs grow, and the processes of creation and redemption are what keep ETFs in line with their underlying values. The halt in UNG’s creation jolted the price of the fund away from its underlying value as fund managers rushed to request an additional $1 billion in shares.

As fund managers were awaiting approval, the CFTC commenced the aforementioned hearings. When UNG was finally granted its previously requested shares, managers declined to create them, citing the uncertainty of upcoming regulation.

Regulation that limits futures positions would likely impact every fund that uses these contracts to achieve its investment strategy. Deutsche Bank (NYSE:DB), the index provider for DBO, declined to comment on the CFTC hearings for this story. Thus far, DBO seems to be holding up relatively well, gaining nearly 8% in the last month.

Regulation that involves position limits would impact the ability of funds like DBO, USO and UNG to create additional shares. Since these funds purchase more futures contracts each time they grow, a limit on futures could grind growth, and creation, to a halt. This scenario is currently playing out for UNG, and the fund is now trading at an absurd 13% premium to underlying value.

While futures-based commodity ETFs arguably provide the most “pure play” for ETF investors, investors should wait for the dust to settle before investing in a fund like DBO. It is difficult to guess what impact upcoming regulation will have on DBO, so investors are best off sitting on the sidelines for now.

Source: DBO: Uncertainty Surrounding Possible Regulations Means Best to Avoid for Now