The Wall Street Journal, June 3, 2008
Commodity-Price Scapegoats
By Donald L. Luskin
In the political quest to place blame for high food and energy prices, a new
scapegoat has been found: commodity index funds. Politicians of both
parties, energy company executives and farm lobbying organizations all agree
these funds should be regulated or prohibited altogether. Who says this is
an age of political discord?
The Commodities Futures Trading Commission, charged with overseeing these
markets, has said there is no rigorous evidence commodity index funds have
any particular effect on commodity prices – and plenty of reasons to think
that they don't. Nevertheless, it was reported over the weekend that the
CFTC will likely bow to political pressure, and soon announce initiatives to
crack down.
Commodity index funds are especially vulnerable politically. They are a big
target – reportedly, there is about $260 billion invested in them currently.
Among their largest investors are retirement funds for government employees
and teachers, which by their very nature are subject to political pressure.
For example, the organized labor lobby is already trying to get states to
make their funds to stop investing in private equity deals in companies that
won't employ union labor.
These and other investors in commodity index funds hold them for the same
reason that they – and probably you, too – hold plain-vanilla stock index
funds. In both cases, they're a simple, low-risk and low-cost way to get
broad and diversified exposure to a major asset class.
Commodity index funds do what index managers like Vanguard have done for
decades with stocks – invest passively in a portfolio designed to track a
published benchmark index. For stocks, it's generally the S&P 500. For
commodities, the most popular is the Goldman Sachs Commodities Index (GSCI).
The evidence against the index funds is circumstantial at best: Commodity
prices have soared over the same recent period that commodity index funds
have rapidly grown. So the index funds must have caused it.
But coincidence isn't causation. And such causation that can be shown to
exist actually runs the other way: Rising commodity prices cause the dollar
value of commodity index funds to rise, just as rising stock prices would
make a stock index fund more valuable. This accounts for nearly half the
reported growth in commodity index fund assets this year. But if commodity
index funds are such a powerful influence on prices, how can one explain the
fact that not all the commodities in the GSCI have risen?
Over the last year, the agricultural, energy and precious-metals sectors in
the GSCI have risen. Livestock prices, however, have been flat, and
industrial metals are lower on average – with the conspicuous exception of
steel. Steel is up dramatically but is not even in the index.
In the absence of rigorous evidence, are there theoretical reasons to expect
that commodity index funds should affect prices? Yes, if only that when new
buyers enter a market they can be expected to drive prices higher, all else
being equal.
That is no crime, even though some politicians would like to portray it as
such now. But of all investors, index funds should have the least power to
move prices. That has always been one of the great attractions of stock
index funds, and the same principle applies to commodities.
Why? When Warren Buffett buys an individual stock – or when T. Boone Pickens
buys an individual commodity – prices will rise because the market must
incorporate the possibility that these experts "know something." But index
funds buy broadly diversified portfolios (whether it be stocks or
commodities) because they know nothing at all. Does anyone think that the
California Public Employees Retirement System has any superior knowledge
about crude oil or wheat? Of course not.
Unlike other commodities buyers, index funds never take physical delivery of
commodities to store or consume them. They are investors, not hoarders. They
don't divert any supplies from the markets. When their futures contracts
near expiration, they sell them and replace them with longer-dated
contracts. Thus, once their positions are established, they are perpetually
both buyers and sellers in equal proportion.
And index funds, despite their size, pose no threat of market instability.
Held by heavily regulated fiduciaries, they typically don't employ the
enormous leverage available to futures speculators. So when prices are
volatile, index funds will be an anchor of stability.
With increasing demand from emerging economies, the dollar near all-time
lows, and the Federal Reserve holding interest rates below the rate of
inflation, surely we can come up with better explanations for high commodity
prices than the growth of commodity index funds. Sadly, those better
explanations are more difficult to swallow politically.
Mr. Luskin is chief investment officer of Trend Macrolytics LLC. |
