Don’t blame index funds for the commodity bubble

Robert WhaleyAs the U.S. subprime housing bubble began to burst in early 2008, another price run-up had formed in the commodities market, one that would soon lead to record high gasoline prices as well as spikes in basic ingredients like wheat, corn, and cocoa.

Press outlets from Barron’s to Bloomberg warned that a crash similar to the one taking place in housing would soon come, which it inevitably did in June 2009, when commodities futures prices fell back nearly to pre-mania levels.

Photo (right): Robert E. (Bob) Whaley, Valere Blair Potter Professor of Management in Finance and Co-Director, Financial Markets Research Center

The culprits they fingered were reckless speculators who had poured more than $250 billion into commodity index investments by the end of 2009 -- a 50-fold increase from a decade earlier, according to Barclays Capital -- as a hedge against a swooning stock market. Congress quickly joined the chorus of blame, casting commodity index traders as the latest Wall Street villains to score big gains at the expense of Main Street.

“In the last three years, speculators have spent billions of dollars on commodity indexes, and the financial firms selling those index instruments have purchased billions of dollars in commodity futures to offset their financial risks, creating price disruptions for producers and consumers,” Sen. Carl Levin, D-Mich., said in 2009.
Hans Stoll

Photo (left): Hans R. Stoll, The Anne Marie and Thomas B. Walker, Jr., Professor of Finance and Director, Financial Markets Research Center

Levin made the statement upon the release of a 247-page report prepared by the U.S. Senate Permanent Subcommittee on Investigations, which he chairs, condemning the role played by commodity index traders in triggering the price swings of raw materials.

“It is another case of speculative money overwhelming a market,” Levin said, “and federal regulators failing to take the steps needed to protect the market.”

Or is it?

New research from Vanderbilt University professors Hans Stoll and Robert Whaley indicates that commodity index trading is likely not to blame for the commodities bubble and subsequent burst that took place between 2006 and 2009. Even so, commodity index trading may come under closer regulatory scrutiny as part of a new financial reform bill signed by President Barack Obama in July 2010.

“The surge in prices appears to be the result of other factors, principally expectations about inflation and future demand,” write Stoll and Whaley, co-directors of the Financial Markets Research Center at Vanderbilt’s Owen Graduate School of Management. The research was published this summer in the Journal of Applied Finance.

The Senate subcommittee report, they write, “concludes that the increased commodity index investing caused the futures price increase. The statistical evidence provided to support such a claim, however, is scant.”

Labeling index investors as speculators is misguided for several reasons, according to Stoll and Whaley.

Speculators take positions in individual commodities, while indexers hold well-diversified portfolios of commodities. Also, speculators buy or sell commodities based on a directional view about prices, compared to indexers who only buy long positions to reduce the risk of their overall investment portfolio. They also typically use leverage, buying only on margin for example, but indexers are always fully collateralized.

Stoll and Whaley acknowledge that, “it is possible that (index investors’) actions affect the prices of all index commodities.” But after investigating that claim, they found little or no evidence to suggest a link between index trading and commodity prices.

In fact, what they discovered stood in direct contradiction to the Senate subcommittee’s core findings. “Commodity futures markets appear to be quite resilient in their ability to absorb the demands of index investors,” Stoll and Whaley write.


Stoll and Whaley examined three distinct elements of commodity index investing to determine what, if any, disruptive effect it may have on the market.

The first area they studied were the price movements of index commodities. They explain, “Commodity index investing is a mechanical trading strategy based on a set of well-defined and well-known rules … If the commodity index trades are large enough to push prices upward, the prices in all markets should move up concurrently. Put differently, the returns of all futures contracts used in index replication should be highly correlated.”

But that expected level of correlation was nowhere to be found. “To the contrary, we find that the average level of correlation in daily returns during the period January 2006 through January 2009 is surprisingly low,” they write.

The second point Stoll and Whaley considered was the price movements of futures contracts during a four-day period each month when investors must roll out of expiring contracts to avoid having to take possession of actual raw materials.
Stoll and Whaley’s research showed roughly the same price disparity between rolled contracts as found in a normal bid/ask spread. Looking at wheat contractsan area of prime concern for the Senate Subcommittee’s report—the average return differential between January 2006 and July 2009 on expiring contracts was 0.09 percent, less than one-tenth of one percent.

Oil was the only commodity that showed a price change that varied directly with the notional value of the quantity of contracts that had been rolled. But if index investments were the cause, a similar relationship would appear in other commodity futures. “Clearly, the futures market has an enormous capacity to absorb commodity index roll activity,” Stoll and Whaley write.

The third analysis draws upon an empirical framework to determine the price effects of money inflows or outflows from commodity index investing. In this case, the authors found that “scant evidence of causality appeared in either direction.”

Since the Senate Subcommittee report, the press has vilified commodity index investments, as in the July 26, 2010 Bloomberg BusinessWeek cover story, “Amber Waves of Pain.” That story warned investors that when “commodities go up, the commodity ETFs often don’t.”

But whatever the potential risks may be for commodity index investing, Stoll and Whaley argue that the one thing it’s not is speculation.

“Commodity index investing has been described as speculation and has been blamed for the upward surge in commodity prices in 2007 and 2008, largely because it grew over the period,” they write. “This study shows that the ascribed blame is baseless.”

Published Nov 12, 2010 in Vanderbilt Business Intelligence
Copyright 2010 Vanderbilt Owen Graduate School of Management