It’s becoming common knowledge that commodity-based exchange-traded funds (ETFs) have some basic design flaws that not only affect their performance but also have an impact on the very futures markets they’re purported to track.

At the core of the issue is the fact that they’re open-ended funds that invest in assets, usually futures contracts that are essentially close-ended. This has led to major dislocations and caused the funds to move away from the stated mandates of within their prospectuses.

From a structural standpoint, these ETFs -- from the US Oil Fund (USO) to US Natural Gas (UNG) -- have proven to not reliably track the price of the underlying commodity they’re tied to.

This shouldn’t come as a surprise to investors, as the very prospectus for the USO states “will endeavor to match the 30-day average price changes of itself and the ‘Benchmark Oil Futures Contract’ within 10%”. Would you trade the Spyder Trust (SPY) or NASDAQ Powershares (QQQQ) with a 10% tracking error?

At least the Spyder Gold Shares (GLD) hold the purports to hold the physical commodity. For several years this stood in its way of listing related options, but that was resolved in 2006 and overall its approach has served it well in tracking the value of the yellow metal. But this seems to be more the exception than the rule in the land of ever-expanding ETFs.

The Devil I Know

Despite the lack of long-term correlation, investors keep piling into these funds. One of the reasons might be that most retail, and thus the managed funds that cater to them, are not comfortable or encouraged to open and trade futures accounts. This is despite the fact that the economics of futures trading, from leverage to preferable tax treatment, is a more efficient way to hedge or speculate in the commodities price.

Whatever the reason, the rampant growth in ETFs has acerbated the structural problems. Of late we’ve seen products such as US Oil Fund and US Natural Gas forced to make adjustments to what, how, and when they structure and adjust the portfolio.

This was seen just last week in the PowerShares Dollar Index (UUP) -- with the dollar intimately tied to oil prices, it has implicit tail-wagging potential -- when trading was actually halted pending the filing to issue new shares. It should be noted that there was very unusual option activity in the PowerShares Dollar Index the day before the halt -- more than 250,000 of the November $23 calls were bought and someone, having seen the filing and realizing shares were in short supply, gamed the system by scooping up shares and call options, creating a short squeeze.