Last week I suggested that the blame for the sell off in
silver was incorrectly placed on the small speculators’ direct participation in
the futures markets and further added that the volatility we’ve experienced is
going to be with us for quite some time to come. This week we’ll explain the
effect of Commodity Index Traders (CIT’s ) and Exchange Traded Funds (ETF’s) on
the commodity markets.
Commodity Index Traders are a relatively new phenomenon in
the futures markets. They began to gain notoriety as Exchange Traded Funds
based on commodities and started to make inroads with equity investors.
Commodity Index Traders have the same goal as mutual fund managers. They
attempt to mirror the index their fund is matched to. A mutual fund manager of
large cap stocks may try to match the S&P 500’s performance as their
benchmark. A Commodity Index Trader may try to mirror the Goldman Sachs
Commodity Index (GSCI) or, as it was known on the trading floor the, “Girl
Scout Cookie Index.”
The important similarity between these two types of
investment is that they are both, long only. People who invest in these funds
have bought the basket that the manager has acquired. This has, historically,
been a niche vehicle in the commodity markets and gone largely ignored until
the easy money policies following September 11th and the economic
crisis of ’08 devalued the dollar and sparked inflation in hard assets.
The oldest and largest commodity based ETF is GLD. As you
might have guessed, this is the gold ETF. It went public in 2004 and now holds $55
billion dollar’s worth of gold. Since the fund physically owns the gold, they
are responsible for holding more than 36 million ounces of gold at its current
price of $1,500 per ounce. This is the equivalent of more than 7,000 gold
futures contracts. They must adjust for their holdings as necessary to meet
investor redemptions as well as the demands of new subscriptions.
Mutual fund, ETF and CIT managers all have a tough time
beating their benchmarks. They are all bound to act on behalf of the public and
therefore, are subjected to the same shortcomings as the individual
participants’ human psyches. In
practical terms this means that people, the individual investors, are most
anxious to buy at the top and sell at the bottom. When management fees are
factored in, it’s no wonder that gold futures have out performed the GLD since
its inception by more than 5% in price alone.
Furthermore, because an ETF’s trading strategy must be made
public in its prospectus, the managers’ trades are subject to market
manipulation by traders who know what action GLD must take in the markets and
when. The potential for manipulation is directly addressed in their prospectus.
“Other market participants may
attempt to benefit from an increase in the market price of gold that may result
from increased purchasing activity of gold connected with the issuance of
Baskets. Consequently, the market price of gold may decline immediately after
Baskets are created.”
Commodity based ETF’s have exploded in popularity over the
last few years. There are now more than 100 publicly available funds with a
combined net asset value of more than $110 billion dollars invested.
Furthermore, at the market highs in 2008, Commodity Index Traders held more
than 40% of the total commodity futures markets’ open interest, which was worth
an additional $60 billion. This is the money that has created the current price
floors that we are all calibrating ourselves to as the new normal.
The new money added to the commodity markets has roughly
doubled the size of the commodity markets’ capital base and indirectly, brought
untold numbers of new investors to commodity futures products. Considering that
this money is almost exclusively individual investors on the buy side, it’s
easy to see how general human psychology will exacerbate the highs and lows of
each rally and decline. The new normal will be higher volatility on the greedy
path to new highs as people climb on board followed by higher volatility on the
down side as individuals abandon ship.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
