Navigating Markets in the Age of Index Funds; the Massive Influx of Capital into Commodity Futures from Index Funds Has Changed Some Basic Market Relationships and Created Both Opportunities and Dangers. We Will Examine the Opportunities Provided by This Capital and Show You Methods to Exploit It as Well as Help You Avoid Danger

Article excerpt

In the world of commodity trading, long only commodity funds (LOCF), or index funds as they are otherwise known, have come to dominate the futures industry through both their sheer position sizes and the constant swirl of discussion surrounding their future. Nobody can seem to agree on the total capital managed through commodity index funds. Whether you believe their size is approximately $200 billion, as the index managers would have us believe, or $300 billion, as others estimate using CFTC data, one thing is for sure; ignoring this 800-pound gorilla in the room indeed may be very costly. The buy-and-hold style of index funds has changed the basic nature of how commodities trade and these changes can create both risk and opportunity for those who understand the effects of this massive flow of capital.

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STATE OF COMMODITY MARKETS

When we study commodity price movements in recent years, it is clear something has changed. Most major commodity groups have set 10-year highs in 2008 including the meats, grains, energy complex and many of the softs such as coffee and cocoa. Many of these commodity groups have surged so dramatically that it has caused outrage by some consumers.

The reason that prices have risen dramatically over so many different and seemingly unrelated groups is as follows:

1. The weakening U.S. dollar

2. Strong worldwide economic growth

3. Growing demand from developing countries such as China and India

4. Rising worldwide money supply

5. Growth of commodities as an asset class

Although all these factors have contributed to the commodity bull market, only the growth of commodities as an asset class is both new and can be directly linked to large scale buying in the futures market for each of these commodities. "Explosive growth" (right) taken from the Masters Report to Congress shows the dramatic relationship between commodity prices and the size of the index funds.

HOW FUNDS AFFECT MARKETS

Before discussing how to profit from index funds, we must first look at their position sizes.

"Major players," (right) shows position sizes of the index funds compared to commercials and non-commercials (all hedgers and speculators). For the purposes of this comparison, we have excluded long positions held by spreaders. This shows that index funds hold approximately 50% of all long commodity futures positions.

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When dissecting the opportunities and dangers resulting from large index fund participation, we can split our analysis into long-term trading, short-term trading, spread trading and investing in CTAs.

We will start our trading analysis with long-term trading because short-term trading should only be done after considering the expected long-term price movements. Index funds have had the effect of shifting all commodities higher and made all trends more bullish. Therefore, what would normally be fundamentally a down market is now flat to slightly bullish. Market conditions that would justify flat markets have become bullish and fundamentally bullish markets have risen exponentially to prices never seen before. But is this relationship permanent? In "The cure is worse," (page 56) we view a long-term chart of the Goldman Sachs Commodity Index with economic recessions highlighted in grey. It is clear from this chart that a recession is a surefire way to extinguish a bull market in commodities. As prices become increasingly high, production tends to increase. However, these production increases take years for many commodities, which gives the market plenty of time to make a steady stream of new highs. Finally, when a global slowdown, or even worse a recession begins, prices in most commodities enter a multiyear bear market. Additionally, once production increases are brought online, production tends to stay high for several years, furthering the bear market. …