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.
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” 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,” 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.
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,” 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 multi-year bear market. Additionally, once production increases are brought online, production tends to stay high for several years, furthering the bear market.
Long-term traders should be long or flat if:
•Index funds continue to hold large long positions.
•The trend in the commodity is flat to up.
•The world economy is growing.
Long-term traders should be short or flat if:
•The trend is clearly down (not flat).
•The world economy is weakening or in recession.
•Production in that commodity is increasing.
Index funds have changed the nature of short-term trading because unlike traditional traders, index funds never take profits. It is much harder for commodity markets to find equilibrium on an upside move. This has resulted in significantly larger moves in commodity markets. Therefore, never sell into strong upside momentum. If the short-term trend flattens or turns down and you feel a selling opportunity exists, then enter short positions with a defined stop so that you can exit quickly if the short-term trend turns bullish.
Conversely, it can be very profitable to join the upward momentum. However, prices can get extremely overextended and far beyond what fundamentals would dictate and therefore it is important to take profits when the upside momentum subsides.
CALENDAR SPREAD TRADING
Spread trading in the index fund era is not for the faint of heart but can be profitable. A bull spread involves buying the front month and selling a deferred month and typically would be profitable in a bull commodity market as the front month would rally more significantly than deferred months. This began to change several years ago as the amount of money in index funds grew. Because the funds had huge positions in the front month and they would have to sell and roll out into a future delivery month, the bull spread failed despite a bull market.
After discovering this tendency, traders began to profit from buying the second month and selling the front month (a bear spread) just prior to the roll period for the index funds. Bear spreads just prior to the index roll period rarely work anymore and often result in large losses. Losses occur because too many traders are involved in this trade causing the market to do the opposite. Floor traders estimate that the amount of money in the market seeking to exploit the “Goldman roll” is near or greater the size of the index funds themselves.
During an index fund driven price spike, spreads can rally significantly. This is because the index funds are typically long the front month which rallies faster during an up move. However, these price spikes rarely indicate a shortage of supply in that commodity and therefore when the momentum subsides, spreads will steadily move back to a normal carrying charge market, which is typical in markets without supply problems. Therefore, use these spikes in the spreads as a selling opportunity: sell the nearby month and buy the deferred month. However, as stated above, try to exit the position before the index funds roll their positions. In essence you are exploiting those attempting to exploit the index roll because that trade is too crowded.
For those who invest in CTAs or other traders, it is important to determine if the growth of index funds may be jeopardizing their future profits. The warning signs that you should carefully consider when selecting or maintaining your investment in a CTA are as follows:
1. Does the CTA derive a reasonable amount of profits from trading commodities?
2. Was their systematic model developed prior to 2005?
3. Has their model been adjusted to reflect how index funds have changed the market?
If the answers to these questions are (1) yes, (2) yes and (3) no then you should carefully consider whether this CTA will remain profitable in the future.
CONCLUSION
The index funds are here to stay and understanding how they affect the futures markets is crucial to your ability to profit over the coming years. For those who jump on the bandwagon of booming commodity prices without understanding the real causes, the results can be disastrous. After over three years of poor performance from 2004 to late 2007, traders finally became significantly long commodities. However, after a lucrative six month run of profits, traders are again suffering as weakening global economies are reversing the long-term price trend of many major commodities. Understanding how index funds affect the markets is the key to staying one step ahead of changing market conditions instead of reacting after it’s too late.
Emil van Essen is the President of VanKar Trading Corporation. His CTA Commodity Spread Trading program attempts to exploit the activity of index funds. He can be reached at 800-258-4403.
