Can USCF's new fund tackle the natural gas contango?

United States Commodity Funds' new ETF, the U.S. 12-Month Natural Gas Fund (NYSEArca: UNL), began trading yesterday, offering investors another easy access point to the natural gas market. But let's hope it sees smoother sailing than its controversial cousin, the U.S. Natural Gas Fund (NYSEArca: UNG).

Not only have regulators vociferously blamed UNG for distorting the commodity markets earlier this year, the fund has also performed dismally to date, dropping a whopping 61.24 percent since the beginning of the year. And it's not because investors have lost their taste for the fund: Last month, UNG still saw brisk inflows of $308 million, even as its net assets dropped $263 million.

Record-low natural gas prices have played their part in slashing UNG's returns, of course, but the big anvil weighing the fund down is the market's nasty case of contango. For the better part of the year, the front-month NYMEX natural gas futures contract has stayed cheaper than those with later delivery dates. And since UNG buys only the front-month contract, selling it near its expiration date to purchase the next-nearest month's contract, the fund has been stuck in a wicked cycle of "sell low, buy high" for months now.

UNL, on the other hand, may be able to avoid some (but not all) of the same pricing sting. Instead of focusing solely on the front-month contract, UNL purchases an equally weighted basket of futures contracts with delivery dates in each of the next 12 months. Two weeks from rollover time, the fund sells the front-month contract and buys the one 12 months out, essentially pushing the basket forward in time.

Given that currently UNG must absorb losses across 100 percent of its contracts during rollover, while UNL only experiences losses in 1/12^th of its portfolio, this methodology should protect the latter somewhat from contango's vicious sting. But it can't make UNL entirely immune, considering the furthest-out contracts are still priced substantially above the front-month contract: Yesterday, the December 2009 contract closed at $4.254, while the December 2010 contract closed 45.7 percent higher, at $6.199.

Also consider that at 0.75 percent, UNL's expense ratio is a mite bigger than UNG's (0.60 percent), so when the contango lessens, any cost savings from choosing the former over the latter would naturally erode. And should the natural gas market flip to backwardation, UNL's staggered buying strategy would actually put it at a disadvantage to UNG.

But backwardation's not likely to happen in natural gas—at least, not anytime soon. To see inversion occur, we'd need to start seeing shortages in the physical commodity, yet natural gas stocks just hit an all-time high. In fact, the International Energy Agency recently predicted that even if demand rebounds, due to an extra-cold winter and economic recovery, we'll still see a natural gas surplus that will depress prices until 2015.

Will UNL ultimately outperform UNG until then? Obviously only time will tell, but we may be able to divine some clues from USCF's other 12-Month Oil Fund (NYSEArca: USL) and its UNG-analogous partner, the U.S. Oil Fund (NYSEArca: USO). Despite oil's price recovery, the commodity has also experienced heavy contango recently, and year-to-date, USL is up 38.84 percent, while USO is only up 22.87 percent.

Still, while I'm always happy to have more tools in the box, when it comes to natural gas, I'm not yet sure whether a flathead or a Phillips screwdriver would be better.

IndexIQ’s new IQ Arb Merger Arbitrage ETF just started trading, but I’m not sure I buy it.

The new ETF (NYSEArca: MNA) launched today, as Cinthia covered in the news. She does a good job laying out the core objective: Buy the stocks of companies that will be gobbled up, and short out a bit of broad market exposure, thus capturing only a theoretical premium of the merger companies.

There’s nothing inherently flawed in the idea here, and I have no doubt that the IndexIQ guys will deliver on the letter of the prospectus. I’m just unconvinced this is a strategy that needs an ETF.

Like most niche ETFs, MNA tracks an essentially self-referential index: the IQ Arb Merger Arbitrage Index. This index is a quantitatively based stock-picking index, which selects stocks based on a public methodology available here.

The idea behind the methodology is to perform the function of a hedge fund manager mechanically. Here’s how the methodology works.

1. Look at every company on dozens of international markets, and make a big list of those that are the subject of an announced merger, acquisition, LBO or private equity investment where more than 50 percent of the company is on the block.
2. At the beginning of every month, when the index is rebalanced, look at the price of the offer in the market, the actual price of the stock, and the price of the stock way back before the deal was announced. Based on those factors, include or exclude each company from the index. The logic is fairly straightforward—companies with offers outstanding over the current price have a higher probability of completing a merge to the upside; companies in the opposite position are stinkers. There’s some nuance, but ultimately, it’s cocktail-napkin logic.
3. These stocks are then weighted based on average trading volume. Companies that are hotly traded get a big slice of the pie. Companies (even big companies, theoretically) that have low liquidity get small weights.
4. Cap every stock at 15 percent, then scale the whole portfolio down to make room for a 10 percent short position using inverse and leverage-inverse ETFs.
5. Any money left over goes in short-term bond ETFs.

Let’s look at the index portfolio this mechanical process currently generates, as of 11/16/2009:

There are obviously a handful of other holdings as well, but the weights drop precariously from here.

The problem I have with this portfolio isn’t that it’s somehow “bad”—I’m not an M&A specialist. Maybe Starent and BJ Services are screaming buys. The problem I have is that by definition, the kind of arbitrage that an active hedge fund manager seeks to exploit is based on asymmetrical information. Many, many smart investors have already weighed the probabilities of, for example, Oracle’s proposal to buy Sun Microsystems. They’re evaluating the books, and perhaps most importantly, responding to news. In the case of nearly every M&A situation, there are blockades that arise and dissolve on a daily basis (in the case of Sun, concerns from European regulators). Those news items often ping-pong a stock’s price back and forth around a hanging offer.

Because an index by definition has to follow certain rules, its hands are tied when circumstances change.

To be sure, there are plenty of loopholes in the methodology to allow IndexIQ to avoid being in stocks that are no longer relevant. But fundamentally, this kind of arbitrage is the most active of active management. It’s about constantly assessing probabilities based on public news flow and private conversations. I remain unconvinced an algorithm, especially a relatively simple one, can capture that.

And last, I hate paying someone to manage my cash. I understand that the ETF needs to have the flexibility to simply not be in the market when there are no opportunities, but that’s not why I’m paying a 75 basis point management fee.

Sorry guys. I understand the intent, and I’m sure the academic finance backs up the algorithm, but I’m not sure I buy it.

[Note: This post originally included discussion of the wisdom of using ProShares ETFs as the vehicle for gaining short exposure. While the index has been constructed using ETFs, the actual portfolio is using futures—a far more sensible and efficient strategy.]

ProShares’ newfound tax efficiency is surprising and welcome. Will the other leveraged funds follow suit?

In case you missed it, ProShares announced today that it will pay zero capital gains on its complete family of ETFs in 2009. That’s shocking, given the huge cap-gains payouts by inverse ETFs in 2008. I would have thought, given the huge run in the market this year, that leveraged funds would have accumulated large distributions.

In fact, I had a half-written blog warning investors to sell out of leveraged ETFs ahead of the 2009 distribution announcements. I was worried that investors would get stuck with large distributions yet again, and didn’t want to see that happen. It was lucky timing that the ProShares announcement jumped ahead of me publishing that blog.

The question now is, will other leveraged and inverse ETF providers like Rydex and Direxion Shares follow suit?

On one level, I think the answer is yes. Given the zero gains at ProShares, it’s unlikely we’ll see the kinds of distributions we saw in 2008, where funds paid upward of 30 percent (and in one case more than 80 percent) of their net asset values in capital gains.

But I wouldn’t look for zero capital gains across the whole universe. The largest gains in 2008 were concentrated in smaller funds, and if I were a tax-sensitive investor, I’d be worried about funds with small assets under management going into the 2009 distribution season.

There are lots of things that ETF providers can do to manage tax distributions, including using the creation/redemption facility to effectively distribute gains to institutional investors during the course of the year. But smaller funds that have less creation/redemption activity are limited in their ability to do this.

My guess is that we’ll still see some capital gains distributions in the leveraged space in 2009, but they will be nothing like what we saw in 2008, and will be focused on the smaller, less-loved funds.

Leveraged and inverse ETFs are most appropriate for traders who may not care about capital gains distributions. But investors in leveraged ETFs outside of the ProShares family may still want to be on their toes as we move into distribution season.

ETF short interest provides some great insights into what the market really thinks.

I’m going to ignore Matt’s twitter-length rebuttal of my last post, and instead point to an excellent set of data that just appeared in my inbox. State Street Global Advisors publishes (as many firms do) a monthly report on the ETF industry. What grabbed me this time was the short-interest report.

It should come as no surprise that ETFs are heavily shorted. After all, one of the great things about ETFs is that phrase “exchange-traded.” It means you can fold, twist and mutilate an ETF just like you can any other stock, and that means that if you can find it to borrow, you can short it. And since many ETFs are phenomenally liquid, they can be pretty easy to locate for shorting.

Overall, short interest in ETFs as reported on Oct. 15 was 11.84 percent. This is substantially higher than the number for the market as a whole; NYSE short interest was 3.51 percent overall. It’s worth nothing that this is a fairly high historical level for the NYSE—it hovers a bit above 2 percent over the last 10 or so years. Given the recent rally in many segments of the market, I’d actually expect it to be high. But what I wasn’t expecting was the extraordinary short-interest levels in certain sectors of the market:

Let’s cut through the haze here a bit. The “Size: Large-Cap” means the S&P 500 SPDR (NYSEArca: SPY). It is—as of the end of October—the most heavily shorted issue on the NYSE, with some 287 million shares short at the end of October. With some 700 million shares outstanding, this explains the lion’s share of that line item. I was equally unsurprised to see the heavy short position in financials, a figure dominated by the sizable short interest in the Financial Select Sector SPDF (NYSEArca: XLF), or small-cap stocks (explained primarily by a huge short interest in iShares Russell 2000 ETF (NYSEArca: IWM), as they’re up nearly 75 percent from the March lows.

But consumer staples? Consumer staples, most easily tracked by the Select Sector SPDR of the same name (NYSEArca: XLP) or the competitive iShares product (NYSEArca: KXI), has been a laggard in the recent stock market rally. While consumer discretionary stocks have been on a tear, putting that sector up 43 percent in the last year, consumer staples—which includes stocks like Procter & Gamble and Wal-Mart—are up just over 10 percent. From the March lows, of course, all did better, but no matter how you slice it, staples have been a laggard, not a leader.

Granted, you can only call something that has rallied 40 percent a “laggard” with a bit of a wink, but compared with the near-double of consumer discretionary stocks? This surprising bearishness is completely borne out in the options market, where there are 12,611 puts outstanding for November, vs. just 2,759 calls (for a 4.5:1 put/call ratio). By contrast, in XLY, there are 19,471 November puts outstanding to 7,264 calls (or 2.7:1).

Personally, I don’t generally play around with rotating sectors, but this did come as a shock to me. Since ETF shares are destroyed and created based on trading and investment demand, the implication here is that three out of every four shares of XLP exist at the whim of people making negative bets on the sector (of course, those three shares also represent someone else’s long bet, since every short position has an offsetting long somewhere out there.

With all the daily blather about moving averages, double-tops and candlestick formations, this is one indicator I can put some faith in, because it’s a reasonable representation of real traders’ sentiment, and a substantial amount of pent-up purchasing should those shorts decide to cover.

$100 billion in assets by December 2010? In a best-case scenario for Schwab, they’ll be closer to $10 billion.

More realistic would be something like $5 billion. But let’s put the over/under at $10 billion by 12/31/2009 and put something interesting on the line, shall we?

Seriously. One-hundred billion would make Schwab the third-largest ETF provider in the world at current levels, surging past ProShares, PowerShares and Vanguard and nipping at the heels of State Street Global Investors. Having a built-in distribution system is a good thing, but it isn’t THAT much of a good thing.

And I’ll say this: They better get busy if they’re even going to reach $10 billion. We’re one week into the project and they’re sitting on a combined $17 million spread among four products.

Obviously, one week is not a legitimate test. My point is that Schwab moving into ETFs isn’t like flipping a switch. The bigger impact will be felt as they educate a broader audience of retail investors and financial advisers on the virtues of ETFs in general. That will take time. Eventually, those investors will start to dip their toes into the water with SCHB, maybe build assets in that over time and then branch out as well into a broader pool of ETFs. That’s why I think Schwab will help significantly grow the ETF industry, even above and beyond whatever assets they attract themselves.

I do think Schwab could eventually be a major player in the ETF industry. But it’s not going to happen overnight, and it’s not going to happen to the tune of $100 billion in a year, either.