Abstract
Fundamental economic factors—market demand and supply conditions—provide the most consistent explanation for trends in commodity prices from 2004 to 2011. This paper presents empirical evidence that the rise and fall of commodity prices on a monthly basis can be strongly linked to the value of the U.S. dollar and the world business cycle—in particular, to the strength or weakness in emerging market economies such as China, Brazil, India, and Russia. Despite concerns raised by some policymakers that increased commodity index investment (the financialization of commodities) has driven commodity price movements, numerous academic studies have concluded that index-based investing has not moved prices or exacerbated volatility in commodity markets in recent years. An examination of weekly and monthly net flows into commodity mutual funds reveals that these flows have little or no effect on the overall growth rate of commodity prices. In particular, weekly flows into commodity mutual funds do not lead to future commodity price changes. These results are consistent with academic papers that find little or no impact of commodity index investors on commodity prices in individual markets. The paper concludes by briefly discussing three key factors that illustrate why flows into commodity mutual funds cannot explain commodity price movements.
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Notes
A commodity is generally thought of as a homogeneous product with all units selling at an identical price. A particular type of commodity, however, may have differences in characteristics or qualities that can affect the commodity’s price. For example, lighter grades of crude oil tend to trade at higher prices per barrel than heavier grades of crude oil.
Forwards are “over-the-counter” trades in which a buyer and seller individually come together and agree now to exchange in the future a given commodity at a prespecified price. With futures contracts, investors also agree now to buy or sell a commodity at a future date, but such contracts are traded on exchanges, are highly specified, and are regulated and monitored in the United States by the Commodity Futures Trading Commission (CFTC).
See Opening Statement of Senator Carl Levin (D-MI), Chairman, Senate Permanent Subcommittee on Investigations, Hearing on Excessive Speculation and Compliance with the Dodd-Frank Act, November 3, 2011. Available at http://www.levin.senate.gov/newsroom/press/release/opening-statement-at-psi-hearing-on-excessive-speculation-and-compliance-with-the-dodd-frank-act.
The IMF regularly discusses these trends in its biannual World Economic Outlook. See www.imf.org for details. A recent paper by IMF staff emphasizes the importance of global growth in explaining commodity price movements for commodities that trade in financial markets, such as oil, and ones that do not, such as wine. See http://www.imf.org/external/pubs/ft/wp/2011/wp1101.pdf.
The Investment Company Institute (ICI) collects monthly and weekly data from its members on mutual fund sales, redemptions, assets, cash positions, exchange activity, and portfolio transactions. The number of funds in ICI’s monthly sample is slightly lower than Morningstar’s data because a few small funds do not report data to ICI’s monthly data collection. However, ICI’s weekly data has 29 commodity mutual funds reporting data as of the end of 2011. Using ICI’s monthly and weekly data, this study examines the relationship between net new cash flows into commodity mutual funds and commodity prices from January 2004 to December 2011. This ICI data is confidential and not available to the general public.
The correlation is highest for the S&P Goldman Sachs Commodity Index (S&P GSCI) at 0.62, and is much lower and statistically insignificant for the Dow Jones-UBS Commodity Index at -0.01. This pattern holds even though the majority of commodity mutual funds, holding more than 90 percent of assets under management in the category, judge their performance relative to the Dow Jones-UBS Commodity Index. This finding suggests caution in using correlation between asset levels and commodity price levels to infer any relationship.
As discussed in Section 6, many mutual funds and exchange-traded funds whose investment objectives are exposure to equities, bonds, or money markets also employ derivatives (typically financial futures, options, or swaps) to manage risks or improve returns in a cost-effective manner. These funds are not intended primarily to provide commodity exposure for their investors. Although these uses of derivatives have been a focus by some analysts and policymakers, they are not implicated in the discussion of commodity price trends and thus are not a topic of this paper.
Irwin and Sanders [2010] define open interest as “the total number of futures contracts, long or short, in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery.” See Frenk and Turbeville [2011] for their claim that the increase in open interest is a measure of excessive speculation.
See graph 2.3 on page 13 of the G20 [2011] study group report on commodities for the emerging market contribution to global growth and overall commodity demand growth in China and other emerging markets. Available at http://www.g20.org/images/stories/canalfinan/gexpert/01reportG20.pdf.
See Carter and Smith [2011] for an analysis of how the interaction of demand and supply factors has influenced boom and bust cycles in commodities in the past.
See box 1.4 in Chapter 1 of the International Monetary Fund’s April 2008 World Economic Outlook, available at http://www.imf.org/external/pubs/ft/weo/2008/01/pdf/c1.pdf.
To be sure, the relationship can also work in the opposite direction: rising commodity prices can depress the value of the dollar. For instance, a rise in oil prices may put downward pressure on the U.S. dollar, as the United States is a major oil importer and rising oil prices worsen the terms of trade for the United States.
For the full version of this paper with statistical appendix, please see http://www.ici.org/pdf/per18-03.pdf
Commodity indices can measure commodity prices or total returns to commodity markets. For clarity in this paper, this study uses “Dow Jones-UBS Commodity Index” to denote the price index and “Dow Jones-UBS Commodity Index Total Return” to denote the total return index. See http://www.djindexes.com/commodity/. For the Dow Jones-UBS Commodity Index, the correlation between percent changes in the price index and its total return version is higher than 0.999 in both weekly and monthly regressions. This study therefore uses the total return index in the regressions.
The fundamental regression can explain over 90 percent of the price level if one uses last period’s price level and the two economic fundamentals to forecast the next period’s price level (that is, a static forecast). To be more rigorous, this study also uses a dynamic forecast that uses last period’s forecast of the price level, rather than the actual price level.
Index-based investment strategies are often referred to as “passive” investments because they require following an index’s formula when buying or selling securities or other assets, as opposed to “active” strategies that involve discretionary selection of securities or assets.
Existing commodity price indices (such as the Dow Jones-UBS Commodity Index) maintain fixed weights in the underlying index components (that is, the individual underlying commodities) during the year. Commodity mutual funds that seek to mimic the index, therefore, will be forced to sell positions in commodities that are rising in price and buy positions in commodities that are falling, helping to stabilize commodity prices. For example, suppose that a commodity mutual fund links to an index composed of only two commodities, oil and gold, which contribute equally (that is, 50 percent each) to the index. Suppose that today the commodity mutual fund is “in balance,” in the sense that 50 percent of the fund’s value is exposure to gold and 50 percent to oil. Next, suppose that oil prices rise 10 percent tomorrow. In that case, the fund is now “out of balance” with the index because it has weights of 55 percent in oil (50 percent times 1.10) and 45 percent in gold. To rebalance, the fund must reduce its exposure to oil, potentially helping to offset that day’s rise in oil prices.
This paper focuses primarily on commodity mutual funds because they invest in a diversified basket of commodities. That focus reflects the direction of the debate over “financialization” of commodity markets, which is concerned less with investments directed at individual commodities (for example, commodity ETFs, which are concentrated in precious metals) and more on “massive passives”—investors and investment vehicles like commodity mutual funds that seek broad exposure to commodity prices through commodity indices.
ICI’s definition of commodity mutual funds is consistent with the Morningstar, Inc. classification titled “Commodities Broad Basket,” but this study uses ICI data on assets under management and flows for this category. Morningstar states that “Commodities Broad Basket portfolios can invest in a diversified basket of commodity goods including but not limited to grains, minerals, metals, livestock, cotton, oils, sugar, coffee, and cocoa. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements.” See http://corporate.morningstar.com/us/documents/MethodologyDocuments/MethodologyPapers/MorningstarCategory_Classifications.pdf.
The Dodd-Frank Wall Street Reform and Consumer Protection Act established a comprehensive new regulatory framework for swaps and security-based swaps. Among other things, the Dodd-Frank Act imposed clearing and trade execution requirements on standardized derivatives products. See Core Principles and Other Requirements for Swap Execution Facilities, 76 Fed. Reg. 1214 (January 7, 2011).
Index weights are usually adjusted annually. For discussion of the Dow Jones-UBS index weights and a primer, see the following links: http://press.djindexes.com/index.php/dow-jones-indexes-and-ubs-announce-2012-weights-of-dow-jones-ubs-commodity-index/ and http://www.djindexes.com/mdsidx/downloads/brochure_info/Dow_Jones_UBS_Commodity_Index_Calculation_Primer.pdf.
In addition, investors can gain exposure to emerging market growth indirectly by investing in a diversified commodity mutual fund, as commodity price returns are highly correlated with emerging market growth over the last decade. The ability to gain indirect exposure to emerging markets also helps overcome capital controls that emerging markets countries sometimes enforce, which can make it difficult to invest directly in those countries.
For simplicity, this study ignores the expense ratios of both mutual fund investments and focuses on gross return.
The food and energy component of the Consumer Price Index is often excluded from measures of inflation because it is more volatile. However, it also has been one of the key drivers of overall inflation over the last decade and reflects price changes for an important part of household consumption.
Mutual funds that pursue a managed futures strategy may invest partly in commodity futures, either directly or indirectly via commodity index swaps. This study includes these in Table 3 for the sake of comparison only. This study excludes these managed futures mutual funds in the rest of the analysis because they do not invest exclusively in commodities and remain relatively small in terms of assets compared with commodity ETFs and commodity mutual funds.
In statistical terms, the contemporaneous correlation between net new cash flows to commodity mutual funds and the monthly percent change in the Dow Jones-UBS Commodity Index Total Return is 0.30 for monthly data from January 2004 to December 2011.
The contemporaneous correlation between net new cash flows to commodity mutual funds and the weekly percent change in the Dow Jones-UBS Commodity Index Total Return is 0.166 for weekly data from January 2004 to December 2011. See the regression appendix in the full version of this paper for the results of weekly regressions.
A simple regression that regresses the weekly percent change in the Dow Jones-UBS Commodity Index Total Return against the contemporaneous net new cash flows to commodity mutual funds produces an R-squared of 0.0195, confirming that weekly flows to commodity mutual funds, at best, can explain less than 2 percent of weekly commodity price changes, leaving 98 percent of that variation unexplained.
This study estimates the implied percentage that commodity mutual funds invest in various commodity markets by using the Dow Jones-UBS Commodity Index and S&P GSCI. This calculation uses the fact that more than 90 percent of assets under management are tied to the Dow Jones-UBS Commodity Index, and thus assumes that only 10 percent of assets are tied to the S&P GSCI to arrive at the estimates.
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This paper was presented at the NABE Annual Meeting, October 15, 2012. It was originally published as ICI Research Perspective 18, no. 3 (May 2012) and is used with the permission of ICI.
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Plantier, L. Commodity Markets and Commodity Mutual Funds. Bus Econ 48, 231–245 (2013). https://doi.org/10.1057/be.2013.29
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DOI: https://doi.org/10.1057/be.2013.29