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

Navigating markets in the age of 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.

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