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 commentary 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 article 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.
