Commodity Index Investing and Commodity Futures Prices

Article excerpt

Recently, commodity index investing has come under attack. A Staff Report by the US Senate Permanent Subcommittee on Investigation (hereafter, the "subcommittee report") "...finds that there is significant and persuasive evidence to conclude that these commodity index traders, in the aggregate, were one of the major causes of 'unwarranted changes '- here increases - in the price of wheat futures contracts relative to the price of wheat in the cash market." The purpose of this study is to provide a comprehensive evaluation of whether commodity index investing is a disruptive force not only in the wheat futures market in particular but in the commodity futures market in general. We conclude that: a) commodity index investing is not speculation; b) commodity index rolls have little futures price impact, and inflows and outflows from commodity index investment do not cause futures prices to change; and, c) the failure of the wheat futures price to converge to the cash price at the contract's expiration has not undermined the futures contract's effectiveness as a risk management tool.

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Recently, commodity index investing has come under attack. A Staff Report by the US Senate Permanent Subcommittee on Investigation (hereafter, the "subcommittee report") "...finds that there is significant and persuasive evidence to conclude that these commodity index traders, in the aggregate, were one of the major causes of 'unwarranted changes' - here increases - in the price of wheat futures contracts relative to the price of wheat in the cash market." (See subcommittee report (2009, p.2). The purpose of this study is to provide a comprehensive evaluation of whether commodity index investing is a disruptive force not only in the wheat futures market in particular but in the commodity futures market in general.

The study has four main sections. In the first, we examine the practice of commodity index investing, beginning with an explanation of the economic rationale for including a commodity index investment in institutional portfolios such as those of pension funds and university endowments. The rationale is simple. The returns of commodity index investments are uncorrelated with the returns of traditional assets such as stocks and bonds, and, therefore, provide a significant opportunity to reduce the risk of traditional investment portfolios. This diversification opportunity together with the advent of deep and highly active commodity futures markets has led to considerable growth in commodity index investment over the past decade. Commodity index products have a variety of forms including managed funds, ETFs, ETNs, and OTC return swaps. Many are benchmarked to well-diversified and transparent commodity indexes like the Standard & Poor's-Goldman Sachs Commodity Index (S&P-GSCI) and the Dow Jones-UBS Commodity Index (DJ-UBSCI) and nearly all of them are based on passive, long-only, fully collateralized commodity futures positions. Based on the composition of these indexes, CFTC Commitments of Traders (COT) Supplemental reports that include the positions of Commodity Index Traders (CIT), and futures prices from the respective exchanges, we estimate the total commodity index investment in the US is currently about $174 billion, which is roughly consistent with the CFTC (2008) estimate of $161 billion. About 24% of commodity index investors are index funds, 42% institutional traders, 9% Sovereign wealth funds, and 25% retail investors holding exchange-traded commodity index products.

The second section focuses on the general issue of whether commodity index investing "causes" futures price changes. Since commodity index investing involves a portfolio of commodities, we include a broad range of commodities in our analyses. Six analyses are performed. First, we examine the co-movements of futures prices for commodities known to be part of commodity index investing programs. …