Academic journal article Business Economics

Commodity Markets and Commodity Mutual Funds

Academic journal article Business Economics

Commodity Markets and Commodity Mutual Funds

Article excerpt

Fundamental economic factors--market demand caul supply conditions--provide the most consistent explanation for trends in commodity prices from 2004 to 2011. This paper presents empirical evidence that the rise and fall of commodity prices on a monthly basis can be strongly linked to the value of the U.S. dollar and the world business cycle--in particular, to the strength or weakness in emerging market economies such as China, Brazil, India, and Russia. Despite concerns raised by some policymakers that increased commodity index investment (the financialization of commodifies) has driven commodity price movements, numerous academic studies have concluded that index-based investing has not moved prices or exacerbated volatility in commodity markets in recent years. An examination of weekly and monthly net flows into commodity mutual flinch reveals that these flows have little or no effect on the overall growth rate of commodity prices. In particular, weekly flows into commodity mutual finds do not lead to future commodity price changes. These results are consistent with academic papers that find little or no impact of commodity index investors on commodity prices in individual markets. The paper concludes by briefly discussing three key factors that illustrate why flows into commodity mutual funds cannot explain commodity price movements.

Business Economics (2013) 48, 231-245. doi: 10.1057/be.2013.29

Keywords: commodity prices, mutual funds, index-based investing, financialization

Products such as gold, silver, crude oil, natural gas, corn, wheat, and soybeans are generally thought of as "commodities." These and hundreds of other types of commodities are traded daily around the world. (1) Commodities are traded in the spot market, where a buyer takes immediate (physical) delivery of the commodity. Commodities are also traded in derivatives markets through such instruments as forwards, futures, options, or swaps. (2) These derivatives allow buyers and sellers to set prices for exchanges of commodities at a future date, in the case of forwards and futures, or to hedge against price changes and other risks.

Over the past decade, the prices of many commodities have risen dramatically and have varied widely. In December 1998, crude oil prices troughed at around $10 per barrel, gold was less than $300 per ounce, and corn was less than $100 per metric ton. From there, commodity prices rose considerably, and in 2008 the prices of many commodities hit all-time highs. For example, oil rose above $130 per barrel, gold cost more than $900 per ounce, and corn rose to about $280 per metric ton. As the recent global financial crisis hit global growth, commodity prices plummeted in late 2008 and early 2009. They quickly rebounded with the world's economic recovery.

The rise in raw material prices has raised production and distribution costs for many manufacturers. On the other hand, some U.S. producers, such as corn growers, have benefited from higher commodity prices. For consumers, the rise in commodity prices has pushed up the cost of living and increased uncertainty over the future cost of food and energy. These increases in commodity prices have concerns among policymakers and sparked widespread debate over the causes of these price changes. Many market participants, economists, and analysts believe that economic fundamentals--market demand and supply conditions, including special conditions affecting specific commodities--account for this pattern of change.

Other analysts, however, point to a trend sometimes referred to as the "financialization" of commodity markets--the increase in commodity investment by participants other than producers and users of commodities. In recent years, hedge funds, pension funds, university endowments, mutual fund investors, and others increasingly have made commodity investments to diversify their portfolios and to protect against inflation. Some commentators have called these investors "massive passives," because they use commodity index-linked instruments, such as commodity index swaps, to establish long-term diversified positions in commodity markets. …

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