From the November 01, 2008 issue of Futures Magazine • Subscribe!

Navigating markets in the age of index funds

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.

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