FM: Do you think that they should be reined in? How?
Haar: Absolutely. I don’t expect that to happen in a big way because there are too many interested parties for whom these products are profitable and would probably succeed in avoiding any draconian restrictions. I suspect that unless there are interventions from the government or the exchanges themselves what will happen over time is that due to poor returns investors will lose interest in these products.
FM: These products have become popular because many people anticipated a long-term commodity bull market and the possibility of a hyper inflationary cycle.
Haar: I am not sure how effective they are going to be in performing that function and there are a lot instruments out there. That is the role of gold. There are TIPS (Treasury inflation protected securities). There are a number of different ways that one can make an inflation bet without owning the wheat market or the corn market, which are basically in a carrying charge structure that unless you get the timing perfect, are going to cost you anywhere from 5% to 20% a year, in the case of sugar, in carrying charges where you need to make that just to break even.
FM: We know that these products affect price in the short-term and that they change some spread relationships but what is your opinion on how they have affected price in the long term?
Haar: They certainly avoided the kinds of issues that would have come about if they participated in the spot positions or tried to create some sort of corner by buying physicals as well as the futures. Most of the impact has been on spread but there has been, in addition to the short-term volatility, some decline in the correlation between cash and futures. [This] has affected basis trading, with wheat being the most egregious case where they have come close to destroying the Chicago wheat contract as an effective hedging tool.
FM: How is this different than the commercial side exerting its influence over the market in the past?
Haar: There have always been imperfections in the system having to do with the nature of the delivery mechanism. The fact that some of the largest hedgers controlled some of the key delivery points created price distortions. There is no doubt about that. But to have a situation where at times in the past year the cash wheat market was $1 to $2 under the futures market in my experience is unprecedented.
FM: What is your opinion on some of the regulatory efforts that would make it more difficult for these funds to operate?
Haar: The clearest thing would be to just not give a hedge exemption to any entity other than a commercial buyer or seller of the underlying physical commodity that is in the business of dealing with the commodity subject to these restrictions. The futures markets can’t function under the idea that they are serving as an inflation hedge to investors. Again, there are other products that can serve that function. The gold market [is one]. There are index contracts like Goldman Sachs futures or Dow Jones UBS futures but the problem is there isn’t enough liquidity for those people to participate. So they are using other futures markets for individual commodities as a surrogate to put together the index. I don’t think that the market [can] handle it.
In the case of soybeans, index funds are long at the moment 175,000 contracts. That is 875 billion bushels, which is roughly five or six times the size of the carryout this year. In the case of wheat, it is even more ridiculous. There [are] basically 1.125 billion bushels of index fund positions which is more than the carryout for wheat this year and soft red wheat production this year is only 404 million bushels, which is the specific contract specs for the Chicago contract, so you have almost 3 times index fund positions than the size of the whole crop. I don’t see how the markets can function effectively with that kind of distorted participation.FM: Talk a little bit about your trading philosophy.
Haar: My philosophy, which I learned from making losing trades, is to stay humble, recognizing that I don’t really know which direction the markets are going to take, no one does. What I try to focus on is assessing the probabilities of different scenarios occurring and try to filter through existing situations to find risk/reward opportunities that look attractive. As a result of that process because of all the unknown factors for any commodity, in my opinion, the proper position as a speculator to have most of the time in most markets is no position. It is only when you reach a certain situation where analyzing the supply/demand situation, analyzing trends in climate, analyzing the political situation and the direction that those variables are likely to find situations where it seems as if there is a 50/50 chance of the market going down 5% or up 10-15%, if a certain event occurs. If you can asses those probabilities correctly, then those are bets you should place and ultimately over time you will do well not really ever knowing because of the 50/50 nature, exactly what the market is going to do. On top of that is experience with money management, position sizing and risk control.
FM: How did your philosophy change from hedging cash risk to trading for investors?
Haar: In some respects the speculative side is easier. You have the luxury of picking and choosing the points when you want to participate in the markets. If you are a soybean processor, you have to come in every day and have some sort of approach to not only the futures price in Chicago but also the cash basis levels, transportation risk and currency risk. You also have to stay on top of customer risk in terms of credit. It is a much more complex situation with many more variables. Now I am only focused on the flat price or the relative value between the different futures contracts I trade.
Also, what I have always enjoyed in my life is looking at economic and political analysis as well as incorporating that into the approach to the futures market has become increasingly important in recent years. After the economic meltdown suffered in a global basis in ’08 which we are in the process of emerging from , or not, it is clear that the macro economic variables have become as important or in the short term more important in their effect on market prices than the traditional narrowly focused supply/demand factors for any given commodity. That has made the speculative side more challenging. As a result, I have decreased the size of the positions and numbers of positions because what has occurred over the last couple of years where macro drivers have been affecting all markets is that the correlation between the movement among commodities has increased dramatically where on most given days 80 or 90% of them are going up or down on the same day.