Warning on commodity asset class

by Morton Sosland
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When ingredient prices early in this century appeared driven by demand unrelated to the traditional activities of food manufacturers and other commercial users, questions were asked as to whether this was the cause of exceptional price swings. Why, it was asked, should ingredient price moves be dictated by buying and selling by well financed traders taking positions unrelated to the usual demand-supply?

It is in the past decade that non-traditional trading has loomed so large. Its impact is measured by great expansion in open interest as well as by dramatic price moves. Just recently, the liquidation of large short positions by hedge funds apparently convinced that markets had declined as much as likely caused a rebound in wheat futures. Once again this prompted questioning whether or not these outside activities have undermined the positive role of futures trading.

Two different sorts of trading are seen as new to futures markets that long ago showed their exceptional value to the food industry. One stems from acceptance of the opinion that owning commodities represents an important asset class for investing by providing both diversification and protection against inflation. The second is greatly expanded trading by hedge funds tracking or preceding commodity buying whose positions boost volumes. The result is trading and open interest far exceeding the speculative activity that has been central to futures markets since their beginning in the 19th century.

This new commodity asset class-like equities, preferred stocks and bonds evolved only when it was recognized that indexes were available that reflect commodities in a fairly complete fashion. These indexes in turn are made up of weights of existing futures, joining wheat, corn and livestock futures with cotton and metals of various kinds. Buying the index means buying the equivalent volume of futures contracts, prompting a huge expansion in trading. At the peak, more than $200 billion of commodity indexes were owned by investors seeking what were the purported advantages of owning this “new” asset.

Alas, the supposed advantages of owning commodities as an asset class did not pan out. Commodities showed no diversification plus during the stock market collapse of 2008, falling with equities, but posting no recovery. A compilation by Bloomberg, starting in 2005, shows stocks currently up slightly more than 50% and commodities in the same period down 30%. This record shows almost ten years of poor returns from investing in commodity indexes, leading to diminished interest by investors wanting to own this asset class. The total of assets held in commodity indexes is down $100 billion from its peak.

Describing the “big commodities experiment as a disaster,” the Financial Times interviewed the professors at the Yale School of Management who first proposed the asset class. One of the aims was to explore the consequences of commodities being “financialized.” It is this aspect that has prompted charges that the result has been prices distorted from what demand-supply factors would have created. Denying that “financialization” has had more than a minimal effect, the professors argue that owning commodities still makes good sense in sound investing. This position is taken even though studies reveal that holdings of commodities in institutional funds failed to spread or reduce risks being taken. The lack of correlation, the study proponents say, is due to supply-demand forces and is not explained by stocks and bonds. Any distortions that arise may be explained by “the markets being invaded by a large colony of new speculators.”

While the idea of commodities as an asset class has many critics and doubters, including large investors that have altogether abandoned commodity investing, others still believe such holdings are vital for diversification and as an inflation hedge. The past decade has shown how such trading, at times almost out of hand, may prompt unrealistic price moves. Knowing that should be warning enough in the event that food ingredients are once again converted to an asset class everyone wants to own.

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