This information will come somewhat as a surprise to investors who have been following the drama behind the scenes at UNG. On July 7 UNG was forced to halt creation of additional shares when the pre-approved number was exhausted. UNG initially lobbied to create 1 billion additional units to satisfy growing demand.

The creation process serves two important roles for ETFs. First it allows funds to grow. Through the issuance of new shares, usually 50,000 or 100,000 units, allows for an increase in assets under management and gives investors access to the fund. Second, and perhaps most important, the creation/redemption process keeps the market price of ETFs close to their net asset values.

Since market makers have the ability to completely hedge ETF positions, the creation of units to meet demand keeps the funds in line with their objectives. Market makers can simply sell the ETF, buy back the underlying stock and create more shares when necessary.

The creation process is what separates ETFs from other funds. Halting creation in UNG suddenly causes a problem for market makers who have to hedge their exposure. If you cannot readily both buy and sell shares of UNG, it takes away the motivation to keep a tight, two-sided market.

Cutting off creation turns an ETF into something that resembles a closed-end fund. Closed-end funds regularly trade at premiums or discounts to underlying value, an issue many investors are attempting to avoid when buying ETFs. During the month of July, UNG regularly traded at a premium to its underlying value or NAV. If the creation/redemption process is designed to keep a fund in line with its NAV, the absence of it will inevitably cause things to go out of whack.

While the halt in creation certainly explains the price disconnect, the inflow of assets is a bit murkier. If UNG halted creation of new shares on July 7, how did the fund have such an incredible influx of assets?

A representative from UNG spoke to me about the influx phenomenon. Since settlement on creation units does not happen instantaneously, funds continued to flow in after creation was halted. So while UNG did not issue any more shares after July 7, the assets necessary for those creations flowed in over a longer period.

The Commodities Futures Trading Commission (CFTC) has recently been holding hearings to discuss position limits for the type of futures that make up funds like UNG and U.S. Oil(USO). A restriction on the number of contracts that UNG managers are able to buy would also dramatically affect creation and pricing.

UNG’s response to upcoming regulation has been to restructure the fund. During July, UNG managers began selling the potentially-regulated futures contracts and buying other investment vehicles like swaps. A dramatic change in the construction of the fund will change what the fund “tracks” and should be understood by investors who are considering purchasing the fund.

UNG’s portfolio, previously subject to the regulations of the New York Mercantile Exchange will now expand beyond that reach into OTC territory. As the portfolio shifts from futures to swaps, a host of new questions about liquidity and regulation will beset the fund.

UNG is in the middle of an overhaul and will not go down without a fight. Investors should stay away from UNG until the dust settles, as the very essence of the fund is changing. Already boasting a sophisticated strategy for seasoned investors, UNG is about to become more complex.

Disclaimer

The plan has many critics, and there are big questions about whether it can work, but at this point the market pessimists will not be swayed by anything but the greatest and most perfect plan, and many of the pessimists believe doing nothing aside from financial reform is the right strategy. In contrast to them, there are the eternal optimists whose hopes are lifted by every new government plan; each of which thus far has shown little effect. Therefore, some of the market activity probably came from the marginal investor who was unimpressed with previous efforts. However, a recent report on fund flows does show that hedge funds became net buyers of stocks for the first time since last October.

Either way, the market is moving higher. Sellers have not swept in to pull stocks lower, and volume has been higher as of late. Technical traders will grow more confident if stocks remain above their 50-day moving average, and the money being thrown into the economy will have some positive effect on economic statistics due to the sheer size of the spending. This makes going short an increasingly risky proposition, and the rally is likely to restrain early shorts a few more times before it runs out of steam. Although stocks may not reach their 200-day moving average above 1,000 on the S&P 500, another 80 points for that index, or 10 percent, doesn’t seem out of the question.

The problem with any forecast, however, is that the market increasingly moves based on major events and political interventions. While the nation’s financial power center may be moving from New York to Washington, D.C., we can only hope that Wall Street will continue to move to Main Street, and that the individual investor and taxpayer will emerge victorious from this multi-trillion-dollar tale. In next month’s Fidelity Independent Adviser, we will explore some of these issues in more depth.

Disclaimer