In just a few short years, exchange-traded funds have become the hottest item on the stock-market menu, with U.S. ETFs alone now holding more than $600 billion of investors’ money.
While that’s dwarfed by the $9.3 trillion managed by non-ETF mutual funds, exchange-traded funds have an allure that conventional funds seem to lack: In 2008, when the global financial crisis caused markets to nose-dive, investors still poured $176 billion into ETFs. Although the pace of investments have slowed this year, investors have still stashed $35 billion in new cash into ETFs – even as they yanked $49 billion out of conventional mutual funds, according to a recent report by Strategic Insight.
This popularity is understandable: ETFs trade like stocks, but can be used to target torrid markets such as China, or white-hot investing trends such as gold or commodities.
But ETFs have a dark side, too – involving risks that most investors probably weren’t aware of, but that government regulators are now investigating. Investors need to understand those risks, and make their future ETF-related investment choices accordingly.
The government inquiry could bring a lot of those risks to light.
CFTC Hearing: In the Spotlight, On the Hot Seat
In a hearing on Wednesday – in what amounted to a rare regulatory assault on speculators – the U.S. Commodity and Futures Trading Commission (CFTC) heard testimony from people who produce, manufacture and hedge commodities and commodities-based products. Among the targets of interest were several of the gigantic exchange-traded funds that allow investors to place bets on certain specific commodities, as well as on diversified, commodity-based indexes.
The CFTC oversees regulated futures exchanges and has been examining how those exchanges could dampen energy-price volatility, possibly by limiting the number of "futures contracts" that hedge funds, investment banks and other speculators can control. Wednesday’s hearing was the third the CFTC has held.
Commission Chairman Gary Gensler reiterated his view that the CFTC should "seriously consider" speculative position limits for energy futures trading. The agency plans to publish any rule proposals this fall.
But executives with the ETFs that invest heavily in energy commodities on Wednesday told the CFTC that that the funds were not the cause of the wild price gyrations experienced by crude oil and natural gas.
John Hyland, chief investment officer (CIO) for U.S. Commodity Funds LLC – an industry player with $3.9 billion in assets under management as of March 31 – was one of the big ETF players on the hot seat. Hyland is the CIO of both the United States Oil Fund LP (NYSE: USO) and the United States Natural Gas Fund LP (NYSE: UNG) – two ETFs that are among the largest such products in the world.
The executive said that ETFs provide market liquidity by helping buyers and sellers find each other.
"We believe that the significant increases in energy prices last summer were wholly unrelated to the activities of our commodity-tracking funds using the commodity futures market to hedge the exposure to investors that results from their obligation to track the price movement of a commodity," Hyland said. "In fact, rather than acting as a source of risk, the funds provide investors with a transparent, highly regulated, unleveraged vehicle through which to hedge their pre-existing price risk in commodities."
The U.S. Oil Fund peaked last February at just over $4 billion, and is now down to $2.4 billion. Oil’s sister fund, U.S. Natural Gas, stands at an even-larger $4.5 billion, and is pending approval from the U.S. Securities and Exchange Commission (SEC) to issue even more shares. The size of the funds points to increasing investor interest in energy-based ETF products – and possibly to the potential for increased volatility in the underlying price of both oil and natural gas.
As of last July, investors who bet on commodities – including the energy complex of instruments – had more than $300 billion directly invested just in index funds designed to track the value of commodity futures, reports the Paris-based International Energy Agency (IEA).
The question at the forefront of the CFTC hearings is whether all this interest is properly placed.
Last year, after oil zoomed upward to establish an all-time-record high in excess of $145 a barrel, a CFTC report attributed the near-vertical price escalation and accompanying volatility on supply-and-demand factors.
Walter Lukken, former U.S. President George W.
