It was the fifth of August, nearly a month after one of the funds John Hyland oversees had grown so rapidly that federal regulators had prevented it from issuing new securities. That fund has become the most closely watched exchange-traded commodity fund in recent months and the fulcrum for a regulatory debate that worries the industry.

ETFs are publicly traded funds that invest in indexes of stocks or commodities, akin to unmanaged mutual funds. There are fewer than 20 ETF providers, among them Charles Schwab & Co. Inc.;  iShares, from Barclays Global Investors N.A.; Vanguard Group Inc.; Invesco PowerShares Capital Management LLC, a subsidiary of PowerShares Ltd.; and ProShares, distributed by Profunds Distributed Inc.

Stock ETFs came about in 1993 and thousands exist across most groups of stocks imaginable. But commodity ETFs are a recent phenomenon, the first emerging in 2004, and they're not to be seen as long-term investments, according to industry experts. 

Now Hyland found himself in front of the Commodity Futures Trading Commission, which was investigating possible causes of the wild volatility and surge in oil and gas prices last year. Oil rocketed from less than $90 per barrel at the beginning of 2008 to $147 in July 2008.

Hyland is the chief investment officer of Alameda, Calif.-based United States Commodity Funds LLC, which currently provides six exchange-traded funds that invest in energy commodities. Two of the funds were suspected of exacerbating price changes. In an effort to control such speculative swings, the CFTC is considering imposing limits on how many futures contracts an individual or company may hold. That prospect is throwing cold water on the industry. Fund companies fear that such a "position limit" would apply against each fund as well as against each individual investor, ignoring the fact that an ETF is owned by thousands of investors.

What’s astonishing is that U S. Commodity Funds, in the face of such a crackdown, is launching two more commodity ETFs. No other provider is registering new commodity ETFs, for fear of the expected limits.

The two funds that came under scrutiny were United States Natural Gas Fund LP and United States Oil Fund LP. Because UNG became so large and was the first public exchange traded vehicle that offered exposure to natural gas futures, stories began to circulate that its ETFs must be causing the volatility in oil and gas prices, and possibly the huge surge last year. 

“The United States Natural Gas Fund undermines futures price formation,” said Paul Cicio, of Industrial Energy Consumers of America, speaking on the same panel as Hyland that day in front of the CFTC. The fund, he contended, was purchasing too many futures of a finite commodity as if it were a stock or bond portfolio. “Those mutualizations essentially of the futures market is going to destroy the integrity of futures,” Cicio said.  

In an interview, Hyland defended his fund in part by saying that when prices of oil and gas surged, the number of futures contracts the ETFs held had dropped.

“Commodity ETFs themselves were sellers not buyers,” Hyland said of contracts during the time oil and gas prices surged.

UNG is generally priced according to the price of natural gas delivered at the Henry Hub in Louisiana.

The fund got up to nearly $4 billion in July 2009 from $670 million in February, and owned more than half the open interest in the two near contracts for natural gas futures.  

That’s when Hyland was asked to testify before the commission.

Even as he did so, in August the CFTC revoked limit exemptions for Deutsche Bank AG’s DB Commodity Service LLC and Gresham Investment Management LLC. The exemptions had allowed the firms to go over the limits of holdings in corn, soybeans and wheat. This revocation didn’t bode well for the funds selling energy commodity ETFs.

CFTC Chairman Gary Gensler made the case for position limits as recently as Oct. 21, speaking at the Futures & Options Expo in Chicago, admitting that speculation is important for price discovery, but insisting that large, concentrated speculative positions should not govern the market.

“I believe that position limits should be consistently applied across markets for physical commodities of finite supply,” Gensler said.

So what’s the appeal of commodity ETFs?

Say you want to buy gold but you don’t have the $1,000-plus to purchase a troy ounce of the bullion. The GLD fund, introduced in 2004, offers retail investors a more manageable way to invest in gold.

Thomas Pauly, an ETF analyst at Raymond James & Associates Inc., says commodity ETFs are just an easier way for commodities players to make "diminutive moves" in the commodities markets. But, he cautioned, past performance demonstrates that “these aren’t long-term investments."

As Hyland mentioned during his testimony, large and powerful investors don't need an ETF.

“George Soros doesn’t pay retail,” Hyland told the CFTC. “If you’re the George Soroses of the world or you’re Morgan Stanley or Goldman Sachs, you don’t need USO, you don’t need UNG, and you’re certainly not going to pay the 45 basis points or 60 basis points that we charge. You would just do it directly through futures or you’d do it directly through swaps. We exist to serve people who otherwise would find it difficult or undesirable to themselves to buy futures, so we are a passive vehicle for them,” Hyland said.

Kathleen Moriarty, a partner with corporate law firm Katten Muchin Rosenman LLP who focuses on legal work surrounding ETFs, said they're used by a host of different investors. The list includes institutional investors like pension funds as well as large corporations. Pension funds, she said, may not be permitted by their board or policy to invest in commodities, but may invest in commodity ETFs.

The two new funds offered by U.S. Commodity Funds are the United States Brent Oil Fund LP, whose prospectus was filed Sept. 18, and the already-approved United States 12 Month Natural Gas Fund LP.

Fees charged to purchasers of ETFs range from 15 basis points to 80 basis points. Hyland says U.S. Commodity Funds gets between 45 and 60 basis points from funds under management, which currently total about $6.5 billion. Calculating for just 45 basis points, that would be $29.25 million in revenue for a year.

While stock ETFs cover every conceivable area of equity investments, Hyland says, in the commodities world there are still a lot of niches to be filled, and it's important things to get there first.

That's why U.S. Commodity Funds identified additional investments to track the price moves of natural gas.

Anticipating the prospective trading limits, “UNG’s management has determined that UNG may need to invest a larger portion, or potentially all, of its investments in other natural gas-related Investments in order to continue to meet its investment objective and comply with these regulatory changes,” the company stated in its filings. Those gas-related investments would include cash-settled options on futures contracts, cleared swap contracts, forward contracts for natural gas, and over-the-counter transactions based on natural gas, oil and other fuels.

“My bet is," said Moriarty, "he’s got enough of a diverse number of things he can invest in, no matter what happens. He seems to be a smart guy who knows how to manage a portfolio using different things to invest in."

Paul Justice, an ETF strategist with Morningstar Inc., says it's shrewd to start the Brent crude and the 12 month natural gas funds with varied investments that would work around the pending CFTC regulation.

“Both of these funds are trying to provide investors with the exposure they seek as well as mitigate the regulation from the CFTC,” Justice said. “It’s kind of a wise move by them.”