Commodities have become an investment vehicle. Speculation has divorced the market price from the physical supply-demand price. Futures markets that were once 70 percent hedging and 30 percent speculation are now the reverse.Once the futures markets were ways to hedge price exposure. Farmers and other producers of commodities could lock in a price that made sense and operate accordingly. Users of commodities could lock in a price that made sense in their production schemes. Price surprises could be avoided.
That has changed. Commodities are no longer products or intermediate goods whose prices need to be hedged. They have become an asset class, and futures markets have become their stock markets. That is not quite accurate. With the advent of exchange traded funds -- ETFs -- commodities are now traded like stocks. Not for their intrinsic value, but for their value as chips in the casino.
It is fair to say that speculation has a long history and is needed to keep markets liquid. Speculation is by definition an attempt to profit by movements in prices. John Maynard Keynes is said to have been good at it. Farmers themselves have tried it by simply withholding sale, as in the period directly after World War II. But with the advent of cash settlement, where you no longer have to take physical delivery of your commodity if you hold the futures contract to completion, and then with the advent of the ETF, speculation has moved to a new level.
The series of charts below demonstrates the scale of the commodities distortion. Dare we call it a bubble? The pattern is evident across all classes of commodities except gold. [Gold has been called a currency, and certainly it displays the characteristic of steady appreciation against the dollar.] Supply and demand are plainly overwhelmed by the great swings in prices. (Chart Source: Seeking Alpha.)
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| Major Commodities Indexes |
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| Oil |
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| Food |
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| Coal |
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| Copper |
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| Gold |
Prominent investor Jim Rogers has fingered tight supply and more importantly the easy money policy of central banks as bullish for "physical assets," as he calls commodities. We do not see the tight supply, but we do see the printing of money. Rogers' thesis is that this appreciates the value of physical assets in the same manner as with gold. We see it as providing chips in the casino, and there is no reason the bets should pay off just because they are larger.
Distorted commodities prices, particularly food prices, have real and tragic consequences. Desperation and social disruption across the globe heightens when food is priced out of reach of people. The current crisis in Egypt is sharpened by this effect. (Egypt is also a laboratory of another aspect of commodity distortions, which is the preference given to U.S. industrial cotton farms in contrast to the cotton producers in Egypt, which reduces incomes and standards of living there. This will be taken up in a future Commodities-Resources-Commons segment.)
The Influence of Commodity ETFs on the Commodity Markets
By Chuck Kowalski, About.com Guide
Commodity ETFs and ETNs have become a new and easy way for investors to trade commodities and include them as part of their long-term investment portfolio. However, commodity ETFs have somewhat changed the dynamics of the markets, as some believe this wave of new funds into the markets has increased volatility, ultimately leading to exaggerated moves in commodity prices.
How Commodity ETFs Work
Commodity ETFs are funds that invest in commodities. They typically invest in futures contracts on an unleveraged basis. Money flows into and out of the ETFs similar to the way mutual funds invest in stocks. When people invest money into the funds, the fund manager has to buy a designated amount of commodities – or futures contracts. Oppositely, when a person redeems funds in the ETF, the fund manager has to sell a proportional amount of futures contracts.
There is an obvious flow of money coming into and out of these funds each day. The net result is what you want to follow. You’ll often find that investors tend to put more money into the commodity ETFs that are moving higher. They also have a tendency to avoid the markets that aren’t hot.
Overall Commodity Investments
It is important to note that commodity ETFs typically are not leveraged like futures contracts. Some funds are leveraged 2x or 3x, but not to the degree of futures contracts. In theory, this would drop the likelihood that commodity ETFs lead to over speculation and exaggerated price swings. After all, it is still a large capital outlay and it takes a great deal of money to move markets. However, there are still some underlying concerns with commodity ETFs that might eventually cause greater problems.
The commodity ETFs that invest in the actual commodity, like SPDR Gold Shares (GLD), are supposed to buy actual gold. The fund is currently worth about $72 billion. That means the fund should have bought and is currently holding $72 billion of gold in storage. In reality, that is probably not the case and some experts in the investment world believe this is cause for concern.
It is unlikely that every owner of the SPDR Gold Shares would want to redeem their investment in gold at the same time. If you could picture a stampede of people wanting their $72 billion worth of gold, that is what it would be. What would happen if the fund couldn’t make good on this redemption? Certainly they would pay in cash, but that really isn’t the point.
The issue of commodity ETFs influencing the markets might become clearer if you realize that investors can continue to buy an asset where there is really no claim on it. What if there was only $100 billion worth of a commodity in the world, yet a commodity ETF was holding $200 billion worth of claims on those commodities. Is that how things should work?
A good case could be made that the fund is oversubscribed and they should only be allowed to accept investment dollars in a commodity that they can actually attain for their investors. That sounds good on the surface, but what happens when you have too many dollars chasing too few goods? Yes, the price rises and some times substantially. You would get the same result in price with or without a commodity ETF. An argument could be made that prices would actually be higher if investors could only purchase the readily available supplies.
Commodity ETFs have opened the door to a new crowd of people to invest in commodities and there is actually more money invested in commodities today. Many investors and money managers won’t invest in futures contracts, but now they have a new mechanism to participate in commodities. Commodity ETFs aren’t necessarily to blame for the volatility in the markets. They might be the vehicle that brings extra money to the markets, but you still have the same investor mentality. The only difference now is that there are more investors and more money – that is what causes the wider swings in the market.
Are ETFs To Blame For Over-Speculation, Record-Correlations, And A Potential Crash?
Seeking Alpha
October 19, 2011
ETFs are huge enablers for soaring stock and commodity prices. And like their mutual fund predecessors, ETFs may have encouraged mass over-speculation that will ultimately result in a stock market crash.
ETF investing continues to be a top choice for diversification, targeted exposure, and specific strategies; but they have caused such mass speculation and have inflated prices to such an extent, that their intended benefits may actually be void and nullified by the tremendous risks and unintended consequences they have posed. ETFs have increased speculation, massively inflated stock and commodity prices, and may be responsible for the unprecedented and hugely-risky correlations across all stocks, sectors, and markets.
ETF Overview
Exchange Traded Funds (ETFs) are a revolutionary financial innovation, and provide many benefits for both individuals and institutions. Bought and sold much like stocks, ETFs are listed on exchanges and allow investors to trade them throughout the day. Like mutual funds, ETFs aim at providing diversification and exposure to a wider range of individual stocks or assets. Unlike mutual funds, however, ETFs can be traded all day, since their prices are instantaneously adjusted. Moreover, ETFs are cheaper and easier to invest in than mutual funds.
ETF Uses
ETFs represent a portfolio of individual stocks, and provide an enormous number of uses – from tracking broad stock indices (like the S&P 500 (SPY) or Russell 2000 (IWM), for example), to investing in specific themes or sectors (like technology (XLK), financials (XLF), housing (XHB)), to providing exposure to emerging markets and individual countries (emerging markets (EEM), China (FXI), Brazil (EWZ), etc.), to currency investment (US Dollar (UUP)), Euro (FXE)), to volatility (VXX), to commodities (Oil (OIL), Gold (GLD), Natural Gas (GAZ)), to bonds (TLT, TBT), and even to actively-managed trading strategies. In other words, ETFs are exceptional tools for individuals and institutions to invest in commodities, sectors, countries, bonds, currencies, strategies, and just about any investment theme imaginable. ETFs provide a way for the average person to invest in a wide basket of stocks which he otherwise would not be able to.
ETFs offer many uses for portfolio strategy and asset allocation:
They also provide a slew of reasons why investors should use them as part of their investment approach:
ETF Industry
With so many innovative uses and benefits, it is no surprise ETFs have grown at such a rapid and perhaps unprecedented pace. By May 2011, there were 2,747 ETFs offered by 142 ETF providers and traded on 49 exchanges – adding up to $1.446 Trillion in assets! There were also plans to launch an additional 1,022 ETFs. With such a huge number of ETFs being traded, there is no doubt that ETFs have revolutionized stock market trading – the question now, however, is “how have ETFs affected markets?”
Massive ETF Growth
Since their introduction, ETFs have grown tremendously – from $0.8 billion in 1993 to nearly $1.5 trillion by May 2011:
ETFs’ popularity has soared largely because institutions have embraced them:
ETFs have also made it much easier and more accessible for individuals and institutions to invest in commodities:
Prior to ETFs, investment in commodities such as oil, gold, grains, and others was limited to commodity traders, futures, or buying the physical commodities themselves. ETFs have provided a means for the common investor to buy these commodities from the comfort of his or her home, without any expertise or knowledge of the underlying asset. To make matters worse, the availability of these ETFs and the constant touting by the institutions that sell them, has greatly increased speculation in commodities and tremendously inflated prices. It is easy to understand why we’ve seen such massive rises in commodity prices over the past few years – investors have poured billions of dollars into commodity ETFs in order to profit from the shortage they expect, as China and emerging markets demand more and more commodities and raw materials for their growing economies. The major problem, however, is that it has become extremely hard to track exactly how much of this commodity price surge is due to real demand – as opposed to the inflated demand that ETFs have caused. In other words, commodity prices could be severely out of whack with reality and way beyond where they should be.
ETFs may have offered tremendous benefits when they were introduced, and still continue to offer investors a way to pick specific sectors, themes, individual commodities, etc; but we are at a point where ETFs may have created such investor frenzy and over-investment, that current prices for stocks and commodities may be highly overextended – and set for a sharp pullback.
Mutual Funds vs. ETFs
ETFs have essentially made mutual funds obsolete. For decades, mutual funds were the number one way for investors to diversify and gain exposure to specific strategies and professional money managers. The introduction of the ETF, however, has made it easier, cheaper, and more effective to invest. Mutual funds have therefore seen large outflows over the past decade, as investors who were disillusioned by terrible mutual fund performance have pulled out their money. Investors simply have no good reason to keep their money in mutual funds when so many funds actually underperform and fail to beat the market while still charging high management fees. ETFs are cheaper, easier to buy and sell, and allow investors to bet on whatever they choose.
Mutual Funds, The Technology Bubble, and The Rise of ETFs
In the technology bubble era, stocks rose to extreme levels because investors were piling into technology stocks and, most importantly, mutual funds. Mutual funds were seeing huge inflows of new investors, and the money that came into these “diversified money managers” was then being invested into the stock market – sending stock prices even higher.
Eventually, after millions of investors piled their money into these mutual funds and the stock market in general, the technology bubble collapsed, and the stock market fell, and mutual funds lost their investors billions of dollars. Average investors, professionals, people with retirement accounts like 401ks or IRAs, and others lost a large chunk of their investment value.
Mutual funds are essentially an investment fund led by one or more portfolio managers. These managers accept investments, trying to invest the funds appropriately in order to make their investors profit. Most funds, however, charge a management fee just for investing. Even if the fund does not gain for the year, the manager may still get paid for managing the investors’ money. The investor is actually worse off in the mutual fund than if he owned a stock of the broader market. In other words, the fund manager did worse than the overall market, when he was actually hired by the investor to beat the market.
It is no surprise then, that mutual funds lost a lot of their appeal when the tech bubble burst and when NASDAQ and stock markets fell from 2000 to 2002. A new financial instrument was about to launch into mass popularity – the ETF. Since so many mutual fund managers couldn’t beat the market, why should investors keep their money invested there? If investors just bet on the overall market they could’ve beat the mutual fund’s returns. Yet there were few if any ways for investors to invest in the broad markets; investors would have to buy a very wide selection of stocks that represented the whole market, and track each of those positions to closely monitor the portfolio allocations. The average, and even the professional, trader simply don’t have the means to buy so many stocks and monitor them closely. Yet diversified exposure to the overall market was still available mainly through mutual funds.
The innovation of ETFs, however, largely cuts out the middle man (portfolio manager), lowers fees, and allows investors to invest in broad themes and overall stock indices that track markets. In other words, if the mutual funds were failing to beat the market, why not just bet on the market? ETFs were invented to very closely track the overall markets or sectors by buying a proportional share of stocks to mirror an index or sector. Investors now had an investment vehicle that was pretty much automated, cutting out the costly middle man and eliminating poor investment choices. Instead, investors could now just “buy the market” and expect the 8% return that the market averaged per year, going back 60 or more years.
Irrational Exuberance in ETFs?
ETFs are undoubtedly an amazing innovation in investing, but may have also helped create over-speculation and unwarranted price increases in the underlying stocks and commodities. By offering an easy, cost-effective, and highly-intriguing way of investing, ETFs have created the illusion that investing is less risky than it really is. ETFs have also massively boosted stock and commodity prices, as investors who were once not able to invest in certain stocks or commodities now bid up the prices of the underlying stocks and commodities by buying ETFs.
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