The idea of index funds is a sound one. If active managers are targeting returns to an index, say the S&P 500, why pay more for active management if you can invest in a fund with the goal of replicating that index? It worked as equity managers had difficulty hitting their benchmarks in the latter part of the equity bull market in the 1980s and 1990s, and now on the equity side there are index funds down to the sector and micro-sector levels.
On the commodity side, indexes have existed for decades but it wasn’t until the beginning of the most recent commodity bull market that funds were established to track the performance of the various commodity indexes. By 2003 serious money was being placed in funds benchmarked to the Goldman Sachs Commodity Index (GSCI) and Dow Jones AIG Commodity Index. Former hedge fund manager and investment guru Jim Rogers even created his own index, the Rogers International Commodity Index (RICI) along with licensing various funds tracking the index, based on his belief that we entered a global commodity bull market in 1999.
But the idea of commodities as an investable asset class has detractors and the huge spike in food and fuel costs has many people pointing the finger at these funds as creating the price spikes instead of just exploiting them.
BUT WHAT ARE THESE FUNDS?
Billionaire hedge fund manager George Soros recently told the U.S. Senate that the current boom in commodity index buying reminds him of a similar craze for portfolio insurance that led to the stock market crash of 1987. Tom Price, president and CEO of Price Group and a member of the RICI committee, says that long-only funds have grown because they “take away the fear from the average institution of market calls. [They] don’t carry the margin risk that a lot of people associate with a commodity account.”
William Adams, managing director at JKV Global, agrees, but warns, “Despite the returns, I do not believe that anyone should be over committed to this asset class because of the singular approach to the markets.”
The idea of investing in commodities has come a long way since the pioneering days of commodity trading advisors John W. Henry, Bill Dunn and Keith Campbell. Back in the 1980s the $1 billion investment level was seen as a sound barrier for the strategy. And as those first CTAs reached and eventually surpassed that benchmark, their strategies virtually abandoned their commodity roots and traded nearly exclusively in financial futures. And there lies the rub.
Today, money benchmarked to commodity indexes is estimated to be between $185 and $260 billion. That places funds well beyond the individual commodities’ spec limits so funds replicating the performance of these indexes enter the cash swaps market. There swaps dealers, usually investment banks, make a market based on the index. Those swap dealers in turn hedge themselves in the futures markets. In 1991, the CFTC allowed such a hedge exemption to a swap dealer based on it hedging an established cash position. And today the downstream result of monies invested in these index funds show up as commercial interest in the CFTC’s Commitment of Traders report. The CFTC identifies index traders in 12 agricultural commodities in its supplemental CIT report.
SPEAKING OF PIONEERS
In 1987, Henry Jarecki (see Trader Profile, page 66) developed the Tangible Asset Program (TAP), a methodology to create a mix of commodities to get the highest possible return for the lowest possible volatility. “We started off by trying every possible combination and comparing it with other possible combinations. Today, mathematicians [can determine] what the optimal mix is that gives you the highest possible return with the lowest possible volatility,” Jarecki says. TAP was developed without reference to prior models, because in 1987 there were no long-only commodity indexes or funds available.
The amount of money benchmarked to the DJ-AIGCI jumped from an estimated $2 billion in 2003 to $48 billion at the end of the first quarter of 2008, while benchmarked assets for the S&P GSCI increased from an estimated $12 billion in 2003 to $100 billion at the end of May 2008 (see “Benchmark boom”). However, some experts have noticed a recent decline in the amount of money flowing into commodity index funds and believe it’s perhaps a result of legislators placing the blame on speculators for increases in commodity prices and encouraging more regulation by the CFTC (see Trade Trends). “In the last six weeks, S&P GSCI and DJ-AIG have not been gaining, which indicates that investors are taking profits or [they] are somewhat cautious that the CFTC may change the rules and adopt a see-through policy which will force them to come closer in line with position limits,” says Richard Brock, president of commodity advisory firm Brock Associates.
Jarecki says, “The logic of discontinuing speculation is like if you’re in the middle of a heat wave, [and saying you should] just smash all the thermometers and maybe the heat wave will go away.”
Commodity indexes are structured with a percentage of their values dedicated to various commodity categories — energy, agriculture, metals and livestock. One of the major criticisms of the S&P GSCI over the years has been its heavy weighting on energy. Approximately 77% of the S&P GSCI is weighted towards energy, while energy makes up less of the DJ-AIGCI and RICI, at about 40% and 44%, respectively (see “Weighting game”). S&P does, however, offer options that are lighter on energy with its S&P GSCI Reduced Energy, Light Energy and Ultra-Light Energy sub indexes.
To maintain tradability as the market changes, each index must rebalance its assets. “When you have markets that are moving around, we constantly talk to each other about whether we need to add something to the index or take something out,” Price says. The DJ-AIGCI is reweighted and rebalanced each year in January on a price-percentage basis. The S&P GSCI’s composition is reviewed on a monthly basis and is rebalanced annually in January, with the rebalancing of its component weights based on five year averages of global production. “Many of us in the trade set our watch by [the S&P GSCI],” Adams says. “[It] can create some nice opportunities if you know when to look.” The RICI is rebalanced monthly, which Price says gives it an advantage over indexes that are rebalanced yearly because, for example, if the market for a certain commodity goes down, indexes that rebalance yearly take a much greater hit than one that rebalances monthly.
Adams explains that there are different trading frequencies for different commodities. For instance, crude oil trades 12 contracts per year whereas soybeans trade seven contracts per year. “The fund holds long positions in the nearby futures for each commodity in the fund’s portfolio. As the expiration of the nearby futures contracts approaches, the fund will sell the entire position in the front month and establish a new position, generally of equal size, in the following month. The result of selling the nearby futures contract and buying the next contract month is called ‘the Goldman Roll’ and is generally done between the fifth and the ninth of every month,” Adams says.
Many wonder how pricing is structured for long-only funds when there is a finite amount of product. Adams points out that long-only funds are interested only in speculation, and as a result, they contribute to a considerable portion of the open interest for any commodity futures contract and almost never change their position sizes, so when hedgers reduce their short positions in a manner consistent with the fundamental trends in their respective markets, the funds continue to hold huge long positions.
“This disparity under certain circumstances can fuel rallies because there are no sellers. This puts the shorts on the defensive, fueling the rally even more. The products find their level when contracts near their term,” Adams says.
Price says that pricing structures of commodity indexes are basically a matter of supply and demand. “You have more dollars in an index committed to a certain commodity than there are commodities available, but the assumption is that the index funds always stay ahead of a delivery so they don’t expose themselves to delivery. There’s not a situation in which they would need to take possession of that commodity, so the pricing structure is more a function of perception and supply and demand. Whatever the underlying commodity is trading at, that’s generally where your index should be,” he explains.
ETFs EXPLAINED
There also are several commodity ETFs based on certain indexes. Three ETFs are based on one of the Dow Jones AIG Commodity Indexes and several are based on the S&P GSCI. ETFs allow investors to benchmark performance to a particular index without paying the added cost of an active manager.
In February 2008, the Securities and Exchange Commission (SEC) approved the first actively managed ETF, and in June the CFTC and SEC approved the trading and clearing of futures and option contracts based on shares of the SPDR Gold Trust ETF (ticker: GLD), which marked the first U.S. option offering for a commodity-based ETF.
“Commodity-based ETFs [offer] an opportunity for money managers to get into an asset class that they couldn’t otherwise” get into, says George Simon, partner at Foley & Lardner LLP, who served as issuer’s council for the SPDR Gold Trust approval process. Adams says commodity ETFs may be attractive investments because of their low costs, tax efficiency and stock-like features. Brock says that while commodity ETFs are beneficial because they allow investors to participate in commodity price inflation and add liquidity to the market, they can also be detrimental to the market in general because he says “ETFs and index funds have taken such a large percentage of the open interest and have had such an influence on prices that the market to some degree has lost its function of price discovery.”
Index funds don’t have to be backed by the actual commodity, but ETFs do. Commodity ETFs in general are not responsible for physical delivery. In the case of the gold ETF, shareholders own a piece of the actual commodity. As Simon explains, gold sits in vaults in London and when shares of the GLD product are created, gold bullion bars are deposited into one of the vaults that have contracts with the ETF. Through the process of allocating the gold and un-allocating the gold and allocating it back again over a few days, the trust ends up owning all of the gold bars in the vaults. “Because it’s a grantor trust, the shareholders have an undivided interest in all of the gold, so it’s just like owning it,” Simon says.
Experts are split on the direction that index funds will go. Price expects the growth to continue, while Brock expects the amount of money going into and coming out of index funds to stabilize. He says, “Growth is stopping right now. Investors are taking a cautious approach on what Congress and the CFTC’s going to do on the regulations. If they were to change regulations overnight, it could be devastating for the commodity market because the long position is so large, particularly in the grain markets. If they were forced to liquidate those positions, the psychological and emotional impact on the market would be very negative.” Jarecki says that if Congress does restrict investment in index funds, “short-term there will be a price decline but long-term it’ll cause a big distortion and a big distrust of the American futures market. If the American markets become uncompetitive and choppy, they will move offshore.”