Looking Under The Hood

The index for FCG was actually developed by ISE and Revere Data LLC. It holds 30 constituents in equal weights and rebalances quarterly. By contrast, UNG simply invests in natural gas futures, swaps and other derivative investments, backed by a fixed-income underlying.

The fund's benchmark has a median market cap in the $3 billion range, which Abssy says gives it more of an all-cap style. “On average, it’s going to be a mid-cap offering over time,” he said. “But the index methodology takes more of an all-caps approach.”

A company is included in FCG’s index if it has 50% or more of its proven reserves in natural gas. Names are ranked by four criteria: price-earnings ratios, price-book, return-on-equity and a company’s correlation to the spot prices of natural gas prices tied to front-month futures contracts.

Those four factors are added together and the 30 companies with the highest aggregate scores are included in the index. Another 40 or so names were left out of the last rebalancing, according to Abssy.

All of the stocks are U.S. listed, although some foreign names are included as American Depository Receipts. The fund has a good chunk in such ADRs with slightly more than 17% included in the ETF at the end of February.

But Does It Apply?

Still, not everyone thinks it’s an accurate way to get into the market for natural gas.

“Even though both ETFs are related to natural gas, it’s not an apples-to-apples comparison,” said John Hyland, the manager of UNG.

Historically, ETFs that buy commodity stocks track much more closely to the broader stock market than those buying future contracts of the underlying commodity, he adds. “UNG has historically been more of a commodities play that doesn’t correlate closely with the overall stock market.”

Since its inception in May 2007, FCG has a correlation of about 0.76 to the S&P 500 index. Even more to the point, says Hyland, is that it has a correlation of about 0.93 to the S&P 500’s energy sector. Like FCG, the Energy Select Sector SPDR (NYSE: XLE) also includes crude oil producers.

Hyland says that’s to be expected of an all-stock natural gas fund. “The list of just pure natural gas providers is very slim—when you drill, you find whatever’s down there. You can’t drill and throw away everything but natural gas,” he pointed out.

By contrast, Hyland says in the past 10 years through 2008, natural gas spot prices have moved with about a 0.04 correlation to the S&P 500. (Correlations range from a perfect 1.00 to no relationship at -0 to an inverse relationship at -1.00.) According to the sponsors of UNG, its natural gas index has a correlation of about 0.98 to spot prices. By contrast, FCG’s is around 0.43.

Given the benchmarking differences between each, Hyland says it’s not surprising that UNG hasn’t jumped like FCG in the ongoing rally.

“A substantial recovery in natural gas prices is probably going to be highly related to a longer-term recovery in the U.S. and global economy,” said Hyland.

He also notes that backwardation in natural gas usually comes later in the year—as winter approaches. That usually bumps prices higher on the front end, says Hyland.

“So it makes sense to expect natural gas markets to remain in contango through summer,” he added.

One Hiccup With UNG

A bump in the road might be coming, though. UNG invests in futures contracts and other derivatives. It basically operates as a commodities pool, which subjects it to different regulations than most other ETFs and open-end mutual funds. A part of that regulatory process requires the United States Commodities Funds LLC, which runs both USO and UNG, to formally submit requests to issue new creation units.

In its latest filing, the firm has done just that, asking the Securities & Exchange Commission for permission to offer another 1 million units. (See related column on the situation here.)

The SEC has a record of dragging its feet with such requests relating to UNG. The last time sponsors wound up in this situation in May, the ETF had to close for two days making new creations. Of course, it could still accept redemptions.

And even if the current situation limits UNG’s abilities for awhile, the short-term impact to investors could actually boost share prices to a premium over net asset values. Right now, they’re selling at a slight discount.

Then again, if UNG keeps trading like a closed-end fund for an extended period, real problems could result.

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