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A recent flurry of activity in commodity ETFs has led to a matching flurry of articles on our side, laden with details about fund assets, position limits, and index rules for rolling futures contracts. The nitty-gritty is vital for investors in these complicated funds who want to make sure their investments are safe, but it also makes it too easy to lose sight of the big picture: what first motivated regulators to step into the market, what the shape of regulations are to come, and what all this means for individual investors who want some commodity exposure. We on the ETF research team would like to take a step back and address what we've seen from the Commodity Futures Trading Commission deliberations thus far, what we applaud and what concerns us, and finally the major lesson that ETF investors need to know when investing in markets like commodities.

Should the CFTC really worry about ETFs?

Regulators began to investigate potential manipulation in the commodities futures market back in mid-2007 after the 2006 turmoil in the natural gas markets caused by the risky bets and collapse of Amaranth Advisors hedge fund. Political concerns grew again in 2008 as oil prices soared past $140 per barrel, pulling gasoline prices up with them. Early concerns about market manipulation centered on hedge funds, proprietary trading by banks and other leveraged, flexible investors with opaque portfolios.

In 2009, Congress became interested in commodity ETFs through an investigation of elevated wheat futures prices in 2008. The final report of the Senate Permanent Subcommittee on Investigations, entitled "Excessive Speculation in the Wheat Market," found that indexed investments in the Chicago Board of Trade wheat futures produced sustained high futures prices that even failed to converge to the spot cash prices on occasion. This strikes us as unlikely, because commodity futures index investments never hold the futures to expiration in order to avoid holding any physical commodities. The investors holding agricultural futures to expiry must have been capable of accepting physical delivery, which means that some market force other than forced buying by long-only commodity indexes must have kept futures prices elevated over cash prices in the final days before expiration.

Furthermore, we find it hard to believe that commodity futures index investing threatens major producers, consumers, or hedgers who make up much of the market. These indexes have completely transparent holdings and tend to concentrate in one or two futures contracts, which means that any distortion they produce in the market should be fairly easily quantified. To the extent that arbitrageurs level out the distortion in futures prices across the various contracts, commodity producers actually benefit from locking in their future sales at higher prices due to index buying pressure. The buying pressure from commodity index investments may push up prices for commodity consumers, but markets where consumers demand more certain supplies have historically tended to trade in contango anyway.

The tumultuous markets of the past couple years, with numerous macroeconomic and supply shocks affecting prices, hardly provided good conditions for examining the effects of commodity index buyers in isolation. Although the CFTC certainly has a valid interest in limiting the size of secretive "smart money" positions such as those held by hedge funds and bank trading desks, the plodding and predictable money of indexed investments does not present the same threat of market manipulation. We believe the evidence of persistent distortions caused by commodity indexers' long positions should be stronger before regulators clamp down on one of the very few vehicles that individuals can use to enter these diversifying asset classes.

No two-tier system!

With a lack of clear public communication from the CFTC, most investors face uncertainty about the eventual size and shape of position limits we will face. Early deliberations by the CFTC suggested that it might consider an exemption for brokers to hold large commodity futures positions so long as they are held for clients such as pension funds and foundations. Because large brokers and commodity traders often represent a number of high-net-worth clients or institutions as well as their own proprietary trading, this "look-through" exemption would better match the size of allowable commodity futures positions with the number of investors behind them. However, early indications suggest that the CFTC will not extend the same courtesy to individual investors getting their exposure through an ETF that it will to institutions buying their commodity futures directly through a major broker.

Should the look-through exemption end up in the final regulations, the CFTC would support a two-tier system in which brokers can treat institutional funds as separate accounts but individual funds in an ETF face onerous restrictions on total position size. This would discriminate against the individual investor with little gain; institutional long-only investments account for a very large piece of the commodity futures market, and present the same risk of market distortion as ETFs. If the CFTC feels that financial investment in commodity futures by outside investors requires substantial regulation, it should not matter whether those outside investors are individuals or institutions.

The hedging exemption and unintended consequences

The Law of Unintended Consequences seems to apply to all financial regulation. If there is some way to get around new rules, a crafty banker quickly finds them. Should the CFTC place limits on ETF positions in commodity futures without any look-through provision to allow for their large individual shareholder base, we expect precisely such a loophole will lead to a handful of banks dominating the commodity exchange-traded fund industry by becoming the backing banks for ETNs. Because hedging positions in commodity futures are allowed to exceed speculative limits, any bank such as Goldman Sachs with a significant physical delivery business in commodities could support larger ETNs than rivals. The main reason we think this might not come to pass is because these banks' hedging exemptions could be put to more profitable use as cover for their proprietary trading positions than supporting an ETN for a fixed fee of 50-75 basis points.

Even if ETNs are not used to get around regulation, fund managers have myriad other options. United States Natural Gas has used swap contracts to fill out its portfolio, essentially paying a premium price in return for a broker buying the direct futures positions to get around limits on UNG's direct holdings. Otherwise, investors will just split their commodity investments between more and more ETFs or ETNs as each hits their own position limit, providing little impediment for rising long positions in commodity futures but causing the costs of those investments to rise as they are spread over more traders and more legal vehicles. Short of limiting commodity futures positions to investors approved for taking physical delivery, there is almost no way to prevent the influx of financial speculators seeking diversification.

When bigger is no longer better

ETF investors also need to adjust their behaviour and priorities regardless of the final regulations that come out of CFTC deliberations. We may not believe that the CFTC has legitimate cause to clamp down on the burgeoning assets in commodity ETFs, but we also do not feel that investors should continue to pour money into the largest funds. The transparent trading and massive assets of the largest commodity index funds have made them juicy targets for other commodity futures traders, which we believe has exacerbated the steep contango that continues to hurt long-only commodity futures investments.

If these commodity ETFs present such promising targets for exploitation by other traders, how did they ever get so popular? Why did so many individual investors pour their money into indices that faced a steep contango and awful losses with each monthly contract roll? We believe the answer could be due to a rule that's nearly in the DNA of every ETF investor: We all thought that bigger funds were better funds. In every other market, the biggest ETFs had the most liquidity and lowest trading costs, along with the lowest expenses. Why would it be any different with commodities?

The answer comes from the liquidity and size of the commodities futures market, and the high turnover of the major indices. Bond and equity index funds not only have far more liquid underlying securities, they are very rarely forced to buy or sell a particular security and frequently have a variety of choices to replace any sold position. In contrast, commodity futures index funds have to trade out their entire portfolio several times a year due to contract expiration and face a much smaller exchange-traded market where other market participants can move prices against them. This causes the biggest funds to attract traders who specifically take the other side of their forced trades in order to capture a liquidity premium. With portfolios that turn over as often as monthly, this adverse trading can quickly eat into the returns of large indexes.

Individual and institutional investors flooded the commodities market in search of diversification. However, they might have changed the diversified returns that they sought by pouring in more money than these relatively quiet markets could handle. We may even face an environment where sizable long-only index investments push commodity futures into a near-permanent state of contango. In this case, more flexible indices that can take long and short positions may be the only winners.

It is too early to tell all the long-term ramifications of the recent changes in the commodities markets, but commodity ETF investors need to start looking beyond the typical sieves of assets and trading volume. A commodity futures index with only middling assets tracking it may well provide higher returns due to the lack of flexible speculators explicitly trading against it. Indices that spread their investments across multiple expiration dates of commodity futures such as the UBS Bloomberg Constant Maturity Commodity Indexes should also have an easier time absorbing assets without detracting from returns. One thing is for sure: Bigger is no longer better. Commodity ETF selection will be a little harder now that we all need to learn some moderation.

Bradley Kay is a Morningstar ETF analyst based in the United States.

Disclosure: Morningstar licenses its indices to certain ETF and ETN providers, including BlackRock Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indices.

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