3 Reasons Why Long-Term Investors Should Avoid This Energy ETF

Sophisticated securities are good until they're not. Here's a security that long-term investors should avoid.

Jul 9, 2014 at 10:25AM

In today's market, there are a lot of investments that look good on the outside, but destroy long-term value on the inside. Many investors buy them believing that they offer novel features that enhance long-term returns only to find out that those features actually do the opposite.

The United States Natural Gas Fund, LP (NYSEMKT:UNG) is one of those disappointing securities. Many investors buy into the natural gas ETF believing they are getting low-risk exposure to natural gas, only to find out that United States Natural Gas Fund is mainly a trading vehicle for short-term trades that actually destroy long-term value. And the performance shows it: Since inception, the United States Natural Gas Fund is down 88% versus the S&P 500's rally of 32%.

Despite the bad returns, the United States Natural Gas Fund always seems to find other investors to buy it. Even today, its market capitalization is over two thirds of a billion dollars. Here are three reasons why long-term investors shouldn't buy this ETF:

High transaction costs
United States Natural Gas Fund suffers from high transaction costs due to the way that it's structured. The fund specifically rolls natural gas contracts monthly, meaning that it sells the the expiring month contract and buys the next month contract every month. Because the fund is so big, this type of activity naturally causes significant slippage.

In addition to slippage, the ETF may at times also suffer from contango, where the forward month contract costs more than the current month contract.  Because of this, the ETF may not benefit as much when natural gas prices rise.

No dividends
Dividends are an investor's best friend. Finding a company with a consistent and growing dividend is one of the principle ways long-term investors identify great investments. This is because companies with a solid dividend history typically have sustainable moats and competitive advantages that allow them to earn superior returns on capital. 

The United States Natural Gas Fund does not pay a dividend. It does charge a 0.60% annual fee, however.

Better options out there
Shares of leading natural gas companies like Chesapeake Energy (NYSE:CHK) and Range Resources (NYSE:RRC) are a much better value than the United States Natural Gas Fund. Leading natural gas companies do not need natural gas prices to rise to do well; they just need to increase production/reserves and maintain their profit margins for their stocks to rise. 

United States Natural Gas Fund, on the other hand, requires natural gas prices to continue rising above expectations to cover transaction costs and reward investors. 

The bottom line
Although the United States Natural Gas Fund has rallied 13% year to date and 22% in a one-year span, those positive returns are unlikely to last in the long term. In the long run, the ETF is almost guaranteed to underperform. 

For most long-term investors, it is a better idea to invest in leading natural gas companies themselves. 

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Jay Yao has no position in any stocks mentioned. The Motley Fool recommends Range Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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