Assets in the United States Natural Gas ETF have shot up in the past year. At the same time, the fund (NYSE: UNG) remains one of this year’s biggest laggards on the performance front.

“If you can find a good reason for people being so bullish, please tell me,” said Stephen Schork, president of the Schork Group, which is based in Villanova, Pa.

Heading into Thursday, UNG—which invests in natural gas futures—was down more than 31% in 2009. Just as significantly, the ETF has been dead flat since the broad stock market bottomed on March 9.

During that same period, the United States Oil Fund (NYSE: USO)—which invests in crude oil futures—has soared more than 30%. As a frame of reference, the Vanguard Total Stock Market ETF (NYSE: VTI) is up almost 20%.

Despite such relative under-performance, UNG’s net assets hit an all-time high after Monday’s close of just over $4.5 billion. At the end of March, that figure was just $700 million, and it was just $2.2 billion as recently as May 31. So, in less than two weeks, assets in UNG have more than doubled.

The ETF’s average daily volume has also increased significantly in the past several weeks. It hit 96 million shares last week after averaging about 19 million shares per day since opening in April 2007.

But why the sudden interest? Energy analyst Schork, who consults and conducts research for institutional investors, doesn’t see natural gas prices surging anytime soon. “Current supplies are at or near peak levels. And there’s no relief on the way,” he said.

In terms of demand, industrial production numbers for May issued this week showed that capacity utilization at the nation’s factories and mills were running at all-time lows. “It’s never been this bad,” said Schork. “That’s not good news for natural gas from a fundamental standpoint.”

Still, people are buying, perhaps thinking that natural gas will eventually join the rally.

“Most people are seeing gold, oil and other commodities rallying,” said Schork. “They’re pouring money into UNG thinking they can still get into the early stages of a commodities rally at relatively cheap prices. The thinking is that at some point, natural gas has to rebound.”

Another ETF To Consider

But there’s another side to the play for natural gas. UNG isn’t the only ETF focusing on the sector. The First Trust ISE-Revere Natural Gas ETF (NYSE: FCG) has been around for more than two years. It’s priced the same as UNG with an expense ratio of 0.60%.

FCG is up more than 17% so far in 2009. Just as notable, it has gained nearly 65% during the ongoing rally that started in March.

Its assets, however, haven’t followed suit—they’re stuck around $72.7 million, a fraction of UNG’s levels.

What’s the difference?

FCG invests in the stocks of natural gas companies. As such, the fund doesn’t directly provide exposure to the commodity of natural gas. It also includes some crude oil producers.

“Having some exposure to crude has helped from a return standpoint this year,” said Mark Abssy, indexing and ETF manager at the International Securities Exchange, which helped create FCG’s index.

Crude prices last summer were at historic highs, topping $140 a barrel, before falling all the way into the mid-$30 stage. This year, crude has inched up past the $70 per barrel range. “The index [used by FCG] includes companies like Royal Dutch, Noble Energy and Goodrich Petroleum that have exposure to both natural gas and crude,” said Abssy. “In fact, the index includes a lot of those types of companies.”

The case for investing in futures is that investors can get more direct exposure to an actual commodity’s price movements. But in the recession and subsequent rebound, while natural gas prices have dropped, corporate earnings in that energy subsector have held up better, says Abssy.

“It’s not just a zero-sum game. These companies are still making profits,” he said. “And natural gas providers are considered part of the alternative energy market, which over the longer term could provide residual benefits for stock investors.”

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.