Tracking the trackers – dodgy deals in commodities trading « Mining Blog

Tracking the trackers – dodgy deals in commodities trading

27. May 2011,

The From Money to Metals website/wiki has, since it was set up over three years ago, paid some attention to the growth of Exchange Traded Funds (ETFs) – also known as Index Funds, or Index Trackers.

These funds promise to follow the movement in share prices across a range of stocks – precious metals’ ETFs have proved to be the most popular and lucrative to date. (Indeed, when the London Stock Exchange held an “emergency” open seminar in February 2009 meeting – trying to reassure small shareholders that the future wasn’t that black after the September 2008 “crash”, investing in ETFs was the formula most recommended).

Now, the tracker funds have grown in importance; expanding over the past few years from precious metals (gold and platinum in particular) into backing other traded commodities, including oil and foodstuffs

In a report entitled “Index Investment and Financialisation of Commodities” two Princeton University economists , Ke Tang and Wei Xiong say that: “Prior to the early 2000s, despite liquid futures contracts traded on many commodities, their prices provided risk premium for idiosyncratic commodity price risk; and had little co-movements with stocks.” Put simply: although commodity prices didn’t always reflect supply and demand fundamentals, an upheaval in one industry sector wasn’t necessarily reflected in another

However, say the authors, from 2004 the market changed. New investors began diving into commodities using index funds (which duly swelled from $15bn in 2003 to $200bn odd today). This was partly because investors considered that investing in commodities would offer “safe” returns (as with buying shares directly in a mining or other company) that were hedged against inflation..

But the expansion of “tracking” appears to have encouraged some bad (if not illegal) behaviour on the part of some of the big banks and trading firms. Last Monday (23 May), according to Gillian Tett of the Financial Times (26 May 2011), the Commodity Futures Trading Commission announced that it had uncovered evidence that a trading house engaged in oil price market manipulation.

This wasn’t the first time by any means that such an allegation has been made. Lagt year, JP Morgan was accused of such manipulation in the copper market (and previously with regard to gold futures), and just over the past fortnight we have a number of similar accusations levelled against Glencore – the world’s largest metals, coal, and wheat commodities’ trader – just as it was being admitted to the London Stock Exchange.

What we’ve seen as index funds swelled, says Tett, is that commodities started to display “greatly increased price co-movements”. Between 1986 and 2004, for example, “the return correlation between soybeans and oil was near to zero; from 2004 and late 2009 it surged to nearly 0.6, as correlations between oil and cotton, live cattle and copper jumped to 0.5, 0.4 and 0.6 respectively.” So, does this mean there has been a dramatic recent change in the supposedly basic “rules” that govern market behaviour (when supply is constrained and demand is rising, prices go up; and vice versa) ?

But, Ke Tang and Wei Xiong point out that the Chinese commodities’ markets – which are off-limits to foreigners and thus also index/tracker funds – have been far less correlated than western markets.

Thus, they conclude that the index funds have fuelled these “price spillover” effects, not only inside the commodities world and also between commodity and non-commodity assets too.

Concludes Gillian Tett: “[T]he point about rising correlation is hard to dispute – or ignore. It should certainly give the politicians – and investors – pause for thought.

“Not least because it is harder to change herd behaviour than to clamp down on a rogue hedge fund. Particularly when that herd behaviour is shifting in some subtle – but important – ways.”

Source: Index trackers offer clues to herd behaviour By Gillian Tett , Financial Times 26 May 2011

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