It seems like every other day, regulators are coming up with new plans on how to increase the controls over the commodities markets: Rep. Barney Frank's proposal on limiting derivatives; CFTC chairman Gary Gensler's plans to regulate the over-the-counter market; the CFTC's proposal to close the "Enron loophole" in natural gas ... sounds like Washington's caught a case of regulation fever.
And the impact on commodities exchange-traded products could be staggering, says Gary Gordon, president of Pacific Park Financial. With more than 19 years' experience in finance, Mr. Gordon is a vocal and trusted advocate for investors: Not only does he host San Diego's "In the Money with Gary Gordon" radio show, he's also the editor of the ETF-centric blog and clearinghouse, ETF Expert.
Recently, HAI Associate Editor Lara Crigger chatted with Mr. Gordon about his thoughts on all this proposed regulation, including how position limits are like Prohibition, why position limits might lead to more physical ETFs and which ETFs he's avoiding until the storm blows over.
Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): So what do you think about the CFTC's proposed position limits for energy futures?
Gary Gordon, president, Pacific Park Financial (Gordon): Like most people, I still want to see what's going to shake out. I'd say I have a negative view, but I'm also aware that they're between a rock and a hard place here. But whatever they eventually push through is probably not going to help. That's the sad part of it; one way or another, there will be ramifications.
Obviously, their intentions are to lessen volatility. When oil goes from $70 up to $150, and then down to $35 and back up to $70, you're not just talking about the dollar losing or gaining ground, and you're not just talking about supply and demand; you're talking about people speculating.
Crigger: Do you find a kernel of truth then in what they're saying about speculators driving up energy prices?
Gordon: Well, how we define "speculators" is also an issue. You and me, we're speculators too. If we think oil's going to $150, we want to get some money in there, too.
But the answer is yes: Obviously, you don't have to be a mathematician to realize that, based on the emerging market growth and developed market growth that has happened throughout the past seven-eight years, $70 to $150 for oil doesn't make any sense. Or $150 to $30. You can say the price of the dollar is affecting it, and that's true, and there's a war premium; but the reality is there wasn't 100% demand in six months.
But the problem is, they probably can't come up with a solution that would work. It's like prohibition of alcohol. Back then, they were obviously trying to stamp something out—although in that case, it was completely; here, we're not trying to stop people from completely investing—but it didn't stop people from getting alcohol. It probably increased the price or the volatility of the price, because there wasn't an open market for it. And people went to alternative places to get it.
Crigger: So if limits are put in place here, you think investors will seek out alternatives, like the over- the-counter market or overseas exchanges?
Gordon: The answer is a definite yes. There isn't even a question about that. When people want something bad enough, they're going to get it.
Overseas markets—the Asian exchanges, in particular—are just going to throw open their doors and say, "Hey, come over here!" So it's unlikely that outright restrictions or certain limits will stop it. I don't necessarily believe it's going to be this mass exodus, because I think it depends on what those regulations ultimately look like. Hedge funds would probably go elsewhere anyway, but for adviser and retail money, if that money wants to get exposure, they'd probably be fine.
But it all depends on how it comes through. Say you have position limits—does that mean when you hit a limit, you can just open up a second, third or fourth fund, so that when you add it up, it's like having 10 mini-UNGs, rather than one big UNG [U.S. Natural Gas ETF]? Or does it mean that your company's done? And if your company's done, can another company open up in your place? Or does it mean that nobody can register for new products anymore, because so much has been acquired in the U.S. markets? That's why it's so hard to talk about this. We're sitting here trying to figure out what they're going to do, but who really knows?
Crigger: One of the big criticisms is that when you have huge futures-based funds like UNG holding a significant chunk of the available market in a given commodity, that when they roll over their contracts, it inherently disrupts the market. Do you think that's true?
Gordon: It's hard to know for sure, because most funds have the front-month contracts situation. Not as many people are like GreenHaven [Continuous Commodity Index ETF (NYSE Arca: GCC)], which uses six months of contracts that are balanced out, rather than just the front month. That's supposed to serve as a way to minimize the likelihood that any one contract's rollover will disrupt everything.
Is GreenHaven less volatile in general? It is, but it's not necessarily because of the contracts; it's less volatile probably because it has 17 commodities in the fund. But also within that 17-commodity structure, they don't just have one contract.
Gordon: Well, I think that almost all of them are simply going to have to change. Although I think a lot of people using ETFs won't even be selling; the name will stay the same, and I think you're going to see a lot of people just holding DBC [PowerShares DB Commodity Index Tracking Fund] anyway.
One thing is that in this new regulatory environment, people might tend to invest in the companies that produce the commodities instead. For example, if you look between natural gas companies, like in FCG [First Trust ISE/Revere Natural Gas Index Fund], vs. natural gas the actual commodity—one's down 40% and one's up 40%! It's night and day. So that's one thing.
And because of the credit crisis, you saw exchange-traded notes just fall off the continent. Advisers won't touch them because they can't get insurance. But the truth is, there's not a lot wrong with them, if you have the credit. So the ETNs could pick up substantially, but you'd need the right financial environment.
A couple other things could happen, too. We could see a lot more like gold and silver, where funds invest in the actual physical commodity. I just don't know how that's going to work, obviously, for oil ...
Gordon: They can do it for the metals. An ETF backed by the physical asset, I think that's what the changes are pushing toward. But even then, if it's backed by it or not, wouldn't people still have concerns about just how much is being controlled by the fund—especially once you get into rare earth metals?
Crigger: In a more regulated environment, which commodity ETFs do you think will perform well?
Gordon: Well, I think there's no problem if you want to look at funds backed by the physical commodity; for example, if you want pure gold and you get GLD, or other metals where there's sufficient liquidity. That's the problem with ETNs, as they currently stand; not only their credit risk, but nobody's trading them right now.
In a general sense, if you're looking for a total commodity concept, I think you'd have to go with GreenHaven [GCC], even though it's the most expensive when you add it up. I used to say go with the DJ-AIG Commodity Index that was DJP [iPath DJ-UBS Commodity Index Total Return ETN], until Barclays was under fire. Barclays is well-capitalized now that they got rid of the iShares unit, so I wouldn't really be that worried about DJP, but I still wouldn't recommend it because of the credit risk issues.
With GCC, it has 17 commodities—not too much in any one exposure—and six months of contracts. It's great when you just want the whole basket—you're not looking to play gold or silver or oil alone, but you're looking at everything. If you want that basket, then I'd say GCC is the way to go.
Crigger: Which should investors avoid?
Gordon: At this point, I'd say avoid anything that's in flux. Don't buy it now, when you don't even know how it's going to change. Of course, if you own a commodity fund, don't go rush out and sell it; but if you're new, don't go to anything that's in danger of changing. And right now, they're almost all in danger of changing, except for gold, silver and GCC.