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«Featured Article Index Funds, Financialization, and Commodity Futures Markets Scott H. Irwin*, and Dwight R. Sanders Scott H. Irwin is the Lawrence ...»

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Applied Economic Perspectives and Policy (2010) volume 00, number 00, pp. 1 –31.

doi:10.1093/aepp/ppq032

Featured Article

Index Funds, Financialization, and Commodity

Futures Markets

Scott H. Irwin*, and Dwight R. Sanders

Scott H. Irwin is the Lawrence J. Norton Chair of Agricultural Marketing,

Department of Agricultural and Consumer Economics, University of Illinois at

Urbana-Champaign; Dwight R. Sanders is a professor in the Department of

Agribusiness Economics, Southern Illinois University Carbondale.

*Correspondence may be sent to: E-mail: sirwin@illinois.edu.

Submitted March 2009; accepted December 2010.

Abstract

Some market participants and policy-makers believe that index fund investment was a major driver of the 2007-2008 spike in commodity futures prices. One group of empirical studies does find evidence that commodity index investment had an impact on the level of futures prices. However, the data and methods used in these studies are subject to criticisms that limit the confidence one can place in their results. Moreover, another group of studies provides no systematic evidence of a relationship between positions of index funds and the level of commodity futures prices. The lack of a direct empirical link between index fund trading and commodity futures prices casts considerable doubt on the belief that index funds fueled a price bubble.

Key words: Index funds, commodity, futures markets, prices, speculation, bubble.

JEL Codes: D84, G12, G13, G14, Q13, Q41.

Introduction The financial industry has developed new products that allow institutions and individuals to invest in commodities through long-only index funds, over-the-counter (OTC) swap agreements, exchange traded funds, and other structured products. Regardless of form, these instruments have 40 a common goal – to provide investors with buy-side exposure to returns from a particular index of commodity prices.1 Several influential academic studies concluded that investors can capture substantial risk premiums and reduce portfolio risk through relatively modest investments in long-only commodity index funds (e.g., In the remainder of this article, the term “commodity index fund” or “index fund” is used generically to refer to all of the varied long-only commodity investment instruments. See the discussion in the following section for further details.

# The Author(s) 2011. Published by Oxford University Press, on behalf of Agricultural and Applied

Economics Association. All rights reserved. For permissions, please email:

journals.permissions@oup.com.

Applied Economic Perspectives and Policy

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related production shortfalls are cited, as well as demand growth from developing nations, U.S. monetary policy, and a lack of investment in basic production infrastructure (e.g., Trostle 2008; Wright 2009).

Even though over two years have passed since the 2008 peak in commodity prices, the controversy surrounding index funds continues unabated. For instance, Michael Masters, Portfolio Manager for Masters Capital Management,

LLC, made the following statement at a March 2010 CFTC hearing:

“Passive speculators are an invasive species that will continue to damage the markets until they are eradicated. The CFTC must address the issue of passive speculation; it will not go away on its own. When passive speculators are eliminated from the markets, then most consumable commodities derivatives markets will no longer be excessively speculative, and their intended functions will be restored,” (Masters 2010, p.5).

Joachim von Braun, director of Germany’s Center for Development Research, made these comments at a March 2010 conference linking high

food prices and world hunger:

“We have good analysis that speculation played a role in 2007 and 2008...

Speculation did matter and it did amplify, that debate can be put to rest. These spikes are not a nuisance, they kill. They’ve killed thousands of people,”3.

These statements illustrate the acrimonious and heated nature of the public policy debate surrounding the role of index funds in commodity futures markets.

The purpose of this article is to provide a thorough review and synthesis of the arguments on both sides of the debate about the impact of index funds in commodity futures markets, as well as a careful assessment of the latest empirical research on the subject. We consider empirical studies that test for general bubble-like price activity over the 2007-2008 period, as well as those that specifically link market behavior to index fund positions. This “taking stock” is important given the stakes involved in the outcome of the debate. If index fund investment was responsible for a large bubble in commodity futures prices, difficult questions are raised about the basic price discovery and risk-shifting functions of these markets. New regulatory limits on speculation would likely be justified even if costly to some market participants. If supply and demand fundamentals rather than index investment were responsible for the commodity price spike, then new limits on speculation would not be justified and could do substantial harm to the efficient functioning of these markets. Before delving into the arguments and evidence, we provide an overview of commodity index funds in the next section.





Commodity Index Funds Commodity index investments share the common goal of tracking the broad movement of commodity prices. The Standard and Poor’s-Goldman Sachs Commodity IndexTM (S&P-GSCI), is one of the most widely tracked indices and is generally considered an industry benchmark; it is computed as a (quantity) production-weighted average of the prices from 24 commodity futures markets. While the index is well-diversified in terms of number of markets and sectors, the production-weighting results in a As quoted in: Ruitenberg, Rudy. 2010. Global Food Reserve Needed to Stabilize Prices, Researchers 155 Say. Bloomberg.com. March 29. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=au9X.

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Applied Economic Perspectives and Policy

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Figure 1 Flow of index investments into commodity futures markets Sanders, Irwin, and Merrin (2010) show that roughly 85% of indexrelated positions in agricultural futures markets are held by swap dealers.

In the non-agricultural markets this percentage is likely to be even higher.

However, swap dealers run a much larger “book” of OTC transactions than just index investments. A swap dealer may have a customer who is a traditional short hedger, whose position offsets the long position desired by an ETF. In this case, the swap dealer “nets” the two positions internally and may not have to go to the futures market to place a long hedge if the positions offset one another. If long hedging in futures is required, it may be in a much smaller quantity than the original index swap made with the ETF due to internal netting. Swap dealer netting has been shown to be relatively small in agricultural futures markets, where swap dealers do relatively little non-index business; however, it can be quite large in the energy and metals markets (CFTC 2008). Figure 1 demonstrates the alternative flow of total commodity index investments into net futures positions.

Measuring the size of commodity index investment is no simple matter. In addition to the netting issue discussed above, there are issues related to counting U.S. versus non-U.S. investments, and how to determine what qualifies as an “index” product. The CFTC has developed three different series related to commodity index investment in U.S. futures markets; this reflects the various assumptions about measuring index investment (see Irwin and Sanders (2010) for a discussion of the three series). Figure 2 presents combined U.S. and non-U.S. asset totals in commodity index products collected by Barclays Capital – one of the longest and oldest series available – from the fourth quarter of 2004 through the third quarter of 2010. This series indicates that assets surged by over $200 billion starting in late 2004, reaching a peak of over $250 billion in mid-2008. Following a sharp decline during the recession, assets resumed their upward climb, reaching a new peak of about $300 billion at the end of the third quarter of 2010.7 The plot also reveals that nearly all of the Index investment data collected by the CFTC provides smaller estimates of the assets in index funds.

At the end of the second quarter of 2008, CFTC data indicated the total was $201 billion compared to $269 billion for the Barclays Capital data. The gap between the two series expanded to $132 billion at the end of the second quarter of 2010.

Applied Economic Perspectives and Policy

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Figure 4 Weekly net long open interest of commodity index traders (CIT) and CIT percentage of market (long) open interest for Chicago Board of Trade (CBOT) soybean futures market, January 6, 2004 - September 7, 2010 Figure 5 Weekly net long open interest of commodity index traders (CIT) and CIT percentage of market (long) open interest for Chicago Board of Trade (CBOT) wheat futures market, January 6, 2004 - September 7, 2010 (CIT).8 Trends in the net long positions of CITs in these four markets roughly parallel the overall trends in commodity index investment shown in Figure 2. There are some differences across markets, however. CIT net long open interest in CBOT corn and wheat first peaked in early 2006, and did not exceed this peak until very recently. CBOT soybeans and KCBOT wheat did not reach their first peak until later, in mid- to late-2007. CIT percentage of total market open interest probably best illustrates the sheer size of index fund positions, which has ranged recently from approximately 20-30% of the long side of the market in CBOT corn and soybeans Position data for 2004-2005 were prepared by the CFTC at the request of the U.S. Senate Permanent Subcommittee on Investigations (USS/PSI 2009). We thank the staff of the subcommittee for allowing us to use this data.

Applied Economic Perspectives and Policy

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(O’Hara 2008), it is largely consistent with popular notions. That is, a bubble is characterized by two elements. First, prices are “inexplicable based on fundamentals” (Garber 2000, p. 4). Second, the trading motive itself is unrelated to fundamental values, as market participants believe they can always sell to a greater fool. The end result is the classic market action identified (ex post) as, “... an upward price movement over an extended range that then implodes,” (Kindleberger 1996, p. 13). The economic damage from an asset pricing bubble may be extensive since the market provides false signals about value. In particular, an inflated price may induce the over-production of an asset and misallocation of productive resources.



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