Speculators profit from commodity investors

Speculators on the floors of commodities exchanges have been called many things, but sensitive, or solicitous of the interests of public investors, are not among them.

So it shouldn’t be surprising that one of the ways they have of profiting from the passively investing public is called “date rape”. In the pits, physical or electronic, that means betting against the certainty that commodity index investors’ positions are rolled in a mechanistic manner every month, in known patterns on particular days. The phenomenon could be called index roll congestion, or some other euphemism, but as we noted, these are not people who worry about your feelings.

Commodities indices were devised to provide a transparent, systematic means for the public to obtain exposure to an asset class that gives a diversified return on capital.

Well, actually, they were devised as a way for investment dealers to make money from investors who wanted that diversification. They’ve worked extremely well for the latter purpose, and reasonably well for the former purpose.

For example, the most successful index, the Goldman Sachs Commodity Index, is the benchmark for an estimated $60bn in funds. The Dow Jones-AIG Commodity index would be the benchmark for the second-largest group of funds, representing around $40bn in assets.

The good thing about transparency is that the investor doesn’t have to worry about the market timing skill of the index manager. The only issue is the financial strength of the manager, so that the investor can make sure he will have the ability to execute the transactions and deliver the return.

It is the managers’ job to deliver pure beta, or market risk. And at the beginning of commodities index investing, when the indices were a small proportion of the total market, that could be done with little effect on the market prices.

Goldman, which is not the sole manager using the GSCI as a benchmark, will roll the index positions from one contract month to the next over a five-day period, 20 per cent a day, and commit to delivering the closing price on the commodity on each day.

The DJ-AIG managers do the same on another set of days with their set of contracts. As the volume in indices began to grow, the speculator community began to game the index managers by running up the prices just when the managers needed to roll their positions.

This didn’t hurt the managers, who were committed to delivering the prices on a certain date, whatever the prices were. But it does hurt the investing public.

Jonathan Spencer, the president of Gresham Investment Management, which manages over $2bn in commodities funds that are not passively indexed, says the firm’s research indicates that commodity index investors lose between 100 to 150 basis points a year of yield thanks to the professionals taking advantage of the traffic jam at index roll dates. Last year that would have been particularly painful, since the GSCI lost about 15 per cent, due in large part to the decline in energy prices.

Even so, Mr Spencer says, “We think the index providers (such as Goldman) are a hell of a lot better at providing direct commodity exposure than buying managed futures or commodities.” That 100 to 150 basis points a year of “date rape” is less of a drain than the excessive management fees charged by most commodities trading advisers for using technical analysis programs you could buy on the internet.

It’s the very success of the Goldmans and AIGs that has led to the problem. The US Commodities Futures Trading Commission has started to break out the proportion of exchange traded futures contracts accounted for by index traders. It’s an eye-opener. In the corn (maize) contract on the Chicago Board of Trade, for example, according to the January 9 report, index traders accounted for 412,916 of the 1,779,250 long positions. That’s an easy target for the speculators to shoot at over a known number of days for a known time of day.

I called Goldman to find out what the managers (or, rather, marketers) of the index would say about the issue, but they had other things to do, and were unable to answer my inquiry. In their defence, and in their absence, we can say they deliver what they say they will deliver, which is the closing prices of the commodity contracts on the days they specify. Given the rules-based trading formula, and the sheer size of the funds
they need to service, they do the best they can.

The problem is the very transparency that the indices promise, which is what the investors were demanding. Smaller managers who have more flexibility than the indexers in executing a rules-based trading methodology can reduce, or avoid, the date rape problem.

Gresham, for example, has been ahead of the index providers by about one to three percentage points a year. It uses its managers’ discretion in picking roll dates, and rebalances the portfolio periodically, rather than using a fixed proportion of contracts. The GSCI will do better in a hot energy year, but will also have more volatility.

The indexers are selling the idea of a black box that will solve your investing problems. Unfortunately, the speculators know what’s in the black box.


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