Index funds make up quarter of commods market: John Kemp

picture from forexmenter

-- John Kemp is a Reuters columnist. The views expressed are his own --
LONDON, Oct 27 (Reuters) - Positions held by commodity indices are equivalent to about 20-25 percent of all the open interest in major U.S. futures and options contracts, according to quarterly index investment data released by the Commodity Futures Trading Commission (CFTC). Total investment in commodity indices amounted to $117 billion at the end of June 2009. Around $95 billion was invested in components linked to U.S. commodity contracts
(such as NYMEX crude oil or CBOT corn), with $22.5 billion in components linked to overseas contracts (such as ICE Brent or LME copper). The largest investments are in contracts linked to NYMEX crude oil ($30 billion), U.S. natural gas ($9.5 billion), gold ($6.7 billion), and soybeans ($6.4 billion). But the impact is probably greatest in agricultural markets, where despite
relatively small allocations in dollar amounts, index investments account for an unusually high share of the open interest, in some cases approaching half the total.

* http://graphics.thomsonreuters.com/ce-insight/COMMODITYINDEX-
SCALE-1.pdf
* http://graphics.thomsonreuters.com/ce-insight/COMMODITYINDEX-
SCALE-2.pdf
* http://graphics.thomsonreuters.com/ce-insight/CFTC-INDEXINVESTMENTS.
pdf

COMPREHENSIVE POSITION DATA

The data is based on the "special call" the Commission first sent to 43 major commodity market participants as part of its investigation into whether investors were causing the spike in oil and other commodity prices in H1 2008, using its powers under Rule 18.05, which has been ontinued
since then. The special call was addressed to 16 swap dealers known to have significant index business; 14 known commodity index funds, including asset managers and sponsors of exchangetraded funds (ETFs) and notes (ETNs); and 13 swap dealers not known to engage in significant index business but are major market participants. The call covers all commodity index and index-like business, including ETFs and ETNs, whether held through futures and
options positions on exchanges, or over-the-counter swap deals. It is therefore the most comprehensive measure of the sector.

STILL OVER-WEIGHTED TO CRUDE

Commodity indices have traditionally been weighted heavily towards crude oil and refined oil products. The productionweighted Goldman Sachs Commodity Index has a 53 percent
weighting towards crude oil and another 14 percent weighting to crude derivatives. Other indices have smaller weightings. The Dow Jones-AIG index, now renamed the Dow Jones-UBS index , caps the weighting of any related group of commodities (energy, precious metals, livestock or grains) at 33 percent. Crude oil is currently weighted at just 14 percent with another 7 percent for refined products. But all indices remain over-exposed to oil and products, limiting the diversification benefits they are supposed to provide compared with an investment in a single contract, and exposing them to large roll costs whenever the oil market moves into persistent contango. In response, index operators have introduced variants which cap crude exposure at a lower level. Standard and Poor's offers indices that cut crude exposure from 53 percent in the main GSCI to 41 percent (Reduced Energy Index), 28 percent (Light Energy Index) or even 18 percent (Ultra-Light Energy Index), with similar cuts in the exposure to refined products. But while operators have offered an ever-increasing suite of products, the CFTC data suggests
investors have taken only limited advantage, and remain heavily overweight in the commodities most affected. Index investors, including those in single-commodity ETFs and Tens as well as more diversified baskets, held about 26 percent of all their exposure in products linked to the NYMEX WTI contract, and another 8.5 percent in NYMEX gasoline and heating oil. Probably half the remaining exposure in markets outside the United States, on which the CFTC has not offered a detailed breakout, was to ICE Brent and gas oil. If so, total exposure to oil and refined products is more than 40 percent, which is relatively high. Much of this is probably from investments in ETFs such as the U.S. Oil Fund and represents strong interest from retail
investors pursuing a simple, directional strategy linked to flagship energy contracts. Institutional investors are more likely to have opted for baskets, with capped exposure to crude and products, so are more diversified. Nonetheless, the index investor "universe" is still far too
heavily weighted towards crude and products markets, despite the urging of investment banks and others to adopt more sophisticated second and third-generation index strategies.

INDICES DOMINATE CBOT WHEAT

While most index money is allocated to energy contracts, it has a much greater impact on agricultural contracts, where relatively small dollar amounts represent a larger share of
the overall open interest. On average, index investments were equivalent to about 25
percent of the reported on-exchange futures and options open interest in the contracts covered by the CFTC special call. But investments range from just 14 percent of the reported
open interest in WTI, 19 percent in heating oil and 27 percent in gasoline to 34 percent in cotton, 37 percent in live cattle and lean hogs, and a staggering 45 percent in CBOT wheat. Not all these positions were in exchange-traded futures and options; in fact most were probably held in bilateral swap deals. But since the valuation of swaps is determined by on-exchange prices, and swap exposures can be hedged out into the public markets, the two are closely linked.

Expressing index positions as a share of reported onexchange open interest gives some idea of how large and influential they are in relation to the overall market. The concentration of index positions in CBOT wheat is often cited as one of the reasons why futures prices have failed to converge with the spot market on expiry over the past five years; the concentration is certainly exceptionally high, even by the standard of other agricultural futures markets. It may be too much for the available liquidity provided by other market users.

CFTC REVIEWS INDEX EXEMPTIONS

In August, the CFTC revoked exemptions given to two index operators (Deutsche Bank commodity Index Tracking Master Fund, and one unnamed operator) previously allowing
them to exceed normal position limits in wheat, corn and soybeans. The Commission concluded the specific trading strategies employed did not qualify for a bona fide hedge exemption.
It gave no further details but may have concluded the strategies were too "active" to qualify as passive riskmanagement for a commodity index basket, or that the underlying markets were simply too small for the positions being taken. Both positions will now be run down over time to comply with federal position limits. The Commission stated the withdrawal of these two no action letters was "very specific and limited and does not affect any other no-action or regulatory positions … with regard to these entities or other market participants". But if CBOT's wheat convergence problem continues, the Commission may come under pressure to tighten the limits
further to cut the share of index investment from 45 percent to something more in line with other contracts. Position limits on other contracts are also under consideration as part of the CFTC's review of energy markets. But problems are less pressing in energy, because indices account for no more than 27 percent of on-exchange interest (gasoline) and often less (for heating oil and crude). While interest remains at this level, it seems likely the CFTC
will continue to provide fairly generous exemptions for index operators. They will, however, almost certainly face tougher reporting requirements and may be required to separate the management of (passive) index positions (that will continue to receive generous exemptions) from active and proprietary ones (that will not). But if index investments in oil and natural gas start to show explosive growth, as the USO and U.S. Natural Gas fund did earlier this year, the CFTC will almost certainly step in to limit their market share and prevent either excessive concentration or distortions caused during roll periods.