Behind The Green Curtain – Commodity Index Funds?

By Brad Zigler

Index funds have always had their detractors. Mostly it's been active managers who've inveighed against the "average" or "mediocre" performance of these market trackers.

Now, no less august a publication than Barron's has come out against the critters. On March 24, Barron's weighed in with a cover story by economics editor Gene Epstein which advanced the notion that speculation by commodity index funds has not only fanned the commodities fire but served as kindling as well.

"By one estimate," says Epstein, "index funds right now account for 40% of all bullish bets on commodities."

Epstein claims that the torrent of money flowing into long-only commodity index funds is "naive" and has sent futures prices soaring far above their intrinsic values. If speculators were to follow the "smart" money - that is, that spent by commercial users of the futures markets - he says, they'd instead be selling instead of buying.

Interesting point. Except it doesn't seem to jibe with the numbers. Positions held by index funds averaged only 28% of the open interest in the dozen futures and options tracked in a Commodities Futures Trading Commission pilot program.

The CFTC reports that commercial users' short positions represent about half the open interest in the pilot program commodities. Putatively, these represent selling hedges used by producers to protect future cash market sales from price declines. From this perspective, the dominant players in the pits are the commercials. Overall, the ratio of long index positions to short commercial trades is 62%, so the commercials are dealing with more than just the index funds as counterparties. Indexers are not taking up all the contracts on offer by the commercials.

Source: CFTC ­- April 1, 2008

Epstein frets over two key issues. First, that commercial net-short positions - shorts minus longs - had, in the past three weeks, far exceeded a previous record set in March 2004. The smart money, he reasons, is short for a reason: The commercials know something. Second, he figures speculators will run for the exits if they're spooked by signs of declining demand, sending commodity prices spiraling into a tailspin.

Perfectly legitimate concerns. But again, those pesky numbers get in the way.

Let's look first at how "smart" the "smart" money was back in March 2004. Did that previously high net-short number presage a fall in commodity prices?

Well, yes it did. But not much of a fall. Prices, as measured by the Continuous Commodity Index (CCI), the renamed CRB Index, bottomed out with a 6% loss by June 2004. By September, the index had recovered to its March level and began stair-stepping to new heights. The six-month cycle was wholly consistent with CCI's normal volatility.

With that in mind, ask yourself this: Is it possible that a decline that follows a record net-short reading could simply represent a buying opportunity in a continuing bull market?

Now, about speculators bailing from the market. It turns out that those long index positions are amazingly sticky. When index fund participation was first tracked in the first week of January 2007, long positions accounted for 29% of open interest. The long indexer's share has hardly moved since then, despite the sell-offs. There's actually much more volatility in the commercials' share. Over the last four weeks, for example, short commercial positions shrank 1.1%, while that of long index funds increased 0.2%. Thus, over the past month, the "smart" money got longer along with the indexing naïfs.

Now, don't get me wrong. I'm not saying that there won't be blow-offs. A quick glance at a commodity index price chart should tell you the past month's run-up was especially frothy. A correction of some sort ought to be expected.

There are, however, a couple of things to consider regarding the impact of commodity index funds on the price trend.

First, it's a stretch to characterize index fund investment as purely speculative. Increasingly, investors are adopting endowment-style asset allocations which include commodities as a permanent diversification component. These investors, institutional and individual alike, represent long-term buy-and-hold positions, something quite different from the traditional active commodities trader.

Second, the introduction of new products may actually militate against crowding in the pits. Exchange-traded notes, for example, don't require the direct construction or trading of futures portfolios. Commodity ETNs, because of their possible tax advantage over exchange-traded funds, may be attractive to large taxable investors.

There are products, too, extant or in the pipeline, that could lessen the competition for long exposure. The PowerShares short and double-short gold ETNs (NYSE Arca: DGZ and NYSE Arca: DZZ, respectively) have established a beachhead for these new products. Additional short exposures, as well as long/short plays, are being developed.

None of this, of course, guarantees that commodities will remain buoyant. Smart index investors, however, are likely to continue seeking exposure, not overexposure, to the commodities sector for some time to come.