August 20:Industry Risk - Facts and Fallacies about Commodity Investment Flows

For nearly a decade, institutional investors have been adding a commodity markets exposure to their portfolios as a way to diversify their returns. This trend is now being blamed for the surge in energy prices to record-breaking prices, on the theory that the flow of investment into energy futures has been so large that it has distorted the normal functioning of the market.

Futures Industry - For nearly a decade, institutional investors have been adding a commodity markets exposure to their portfolios as a way to diversify their returns. This trend is now being blamed for the surge in energy prices to record-breaking prices, on the theory that the flow of investment into energy futures has been so large that it has distorted the normal functioning of the market. In the following article, three members of the commodity research team at Barclays Capital shed some light on the commodity investment trend with a carefully gauged estimate of the size of the flows. They also describe the increasingly wide range of investments used to capture commodity market exposure, and refute some of the more common fallacies and misperceptions in the political debate on this issue.

There has been unprecedented interest in commodity investments over the last couple of years. Investor funds have flowed into commodities at the fastestever rate as the sector has moved to the top of the list of favored alternative investment exposures.

At the same time, fundamentals have undergone significant structural shifts, leading to a tightening right across the sector. Growth in the consumption of raw materials in developing economies (primarily China with an additional impact from India, Latin America and the Middle East) has created relentless demand for commodities across all sectors. On the supply side, commodity producers, with no incentive to improve production capabilities during two decades of weak commodity prices, are illequipped to meet increased demand expectations. Supply is further hampered by reserve depletion, shortages of key inputs, and political obstacles. As a result, the price of many commodities has surged to alltime highs this year.

The commodity price boom has stoked the debate about whether speculative inflows have had an instrumental part to play. Many commentators pin the push higher in commodity prices on a "tidal wave" of assets pouring into commoditylinked indices and products. There are widespread claims that the billions of dollars of investment money that are flowing into commodities are distorting prices. Indeed, given the nature of recent press coverage, the casual observer might be forgiven for thinking that commodity prices are all being swept higher on an irresistible tide of speculative buying that is pushing prices ever farther away from fundamental values.

Such an impression would be mistaken. Commodity markets continue to behave in all sorts of different ways, with the most important differentiator between markets and sectors being the trends in supply and demand. Much of the comment on commodity investment is illfounded and confusing. In this article, we assess the new institutional and retail investment activity in commodities, provide some reliable measures of investor flows, and add some context to the current debate surrounding their impact. We also tackle some of the common fallacies in this debate that have contributed to an overestimation of the size and impact of investment flows into commodities.

The phenomenal growth of institutional and retail investment in commodities has been widely observed, but determining the actual size of the trend is not easy because the data is partial and comes from a wide range of sources. In our analysis, we use reported data from various issuer websites and databases to track flows in three types of investments used to obtain an exposure to commodities: commodity exchange-traded products, commodity index-linked mutual funds, and commodity-linked medium-term notes. No comparable data is available for a fourth type of investment�commodity index assets under management attributable to institutional investors�so for this category of investment we can only obtain a rough estimate from various industry sources through a painstaking process of estimation and cross-checking.

Growth in commodity index assets under management that is attributable simply to rising prices is being misclassified as fresh investment buying--A major confusion that exists concerns the lack of distinction between assets under management and fresh flow of funds. The bulk of the increase in commodity index assets under management has simply been due to the surge in commodity prices. As the indices rise, so does the value of indexlinked assets. That is an automatic accounting change that does not represent any new inflow of money, or indeed any intervention or activity at all by investors.

For example, our estimate is that the value of commodity index assets under management rose by $13 billion in Q1 08, and of this $11 billion was simply due to the increase in the underlying indices. The net inflow of new money over the quarter was then about $2 billion, or $30 million per trading day.

Futures market open interest held by index investors is being interpreted incorrectly as directly equivalent to the physical demand for a commodity--This represents a basic misunderstanding of the link between the physical and financial aspects of commodity trading. For commodity futures markets to work in offsetting underlying market risk, a link to the physical market is certainly necessary. This requirement for efficient arbitrage between physical and financial markets is provided by the obligation to either deliver or receive the physical commodity if a contract is held to expiry. It is this option to hold a contract to expiry and make a physical transaction that keeps commodity futures markets tied to fundamentals in the physical markets.

There is no obligation to hold a contract to expiry, however, and in fact very few users of commodity exchanges ever take physical delivery. Most are involved in risk management or financial transactions and either close out or roll their positions forward before they expire. This is why physical material held at delivery points for major commodity futures contracts (eg, crude oil at Cushing Oklahoma or copper held in LME warehouses around the world) need only be a very small proportion of futures market open interest or turnover. Producers, consumers or merchants may from time to time take delivery if it is advantageous to do so, but the index investors certainly will not do so.

Placed into a more relevant context alongside the value of futures market turnover or value of total physical market size, it becomes very clear that institutional and retail holdings of commodity futures are extremely small and nowhere near big enough to distort the relationship between prices and market fundamentals. So, for example, our estimate of the value of index positions in the Nymex oil futures market at the end of Q1 is $43 billion. That is equivalent to around 2.9% of the notional value of monthly turnover, 12% of the value of open interest and only 2% of the value of the global physical oil supply in 2007.

We do not see commodity prices as being a bubble, nor do we see the involvement of institutional investors as being a cause of price rises. Indeed, given that institutional investors rebalance portfolios to achieve a desired allocation across assets, they are generally a stabilizing influence, in that to achieve their desired balance they tend to sell after prices have risen and they buy after prices have fallen. In other words, they do exactly the reverse of what participants in a bubble do.

In terms of more speculative and unhedged money flows, there is also no evidence, in our view, that these flows are keeping prices high. For example, there was a view put out last year that oil price rises had only occurred due to a tide of excess liquidity in the world financial system. Any such excess liquidity disappeared a year ago, and yet prices have continued to rise. The level of open interest in the main oil futures contract reached a peak last July, and its overall level has been, as should have been expected, unrelated to price behavior.

The level of bad information and bad analysis currently active in policy circles and in some media coverage appears to be at record levels. It would then perhaps not be a total surprise if bad policy might flow from bad analysis. The key shortrun downside risk to prices we would then highlight would be some misguided intervention in the operation of the market that might produce some degree of forced liquidation. In those circumstances, any shortterm sharp price dip is likely to produce such a degree of excess demand in the world market that prices would snap back over time. In other words, we would see such intervention as merely creating a distortion and laying the foundations for a significant latter price spike.

Given that we see current prices as rational and fair, it follows that we would view policy aimed at reducing prices as being selfdefeating and distortionary in the medium term. Tackling a bubble that does not actually exist is more than pointless, it is counterproductive in that it stops the correct market signals being sent to both the supply and demand sides of the market.

Investors have a wide range of choices for obtaining exposure to commodity markets. The most commonly used method has been swaps tied to commodity indices, but starting in mid 2007 the primary destinations for investment inflows have been other types of instruments such as exchange-traded products and medium-term notes.

ETPs are an all-encompassing term used to capture exchange-traded funds, exchange-traded notes and exchangetraded commodities. They offer the choice of a range of individual commodities and several different index-tracking securities or funds. ETFs are investment products representing an individualcommodity or an index such as the S&P GSCI that trade like stocks on an exchange. ETNs are debt securities that are listed on an exchange and can be bought, sold, and shorted like a stock. ETCs are open-ended asset-backed securities and can be regarded as secured, undated, zero-coupon notes that trade through an open market-maker platform.

The evolution of ETPs from the time they were first launched has been phenomenal. The first commodity ETPs were launched just five years ago and today there are more than 170 listed on different exchanges worldwide holding in excess of $50 billion in assets under management. Our data for ETPs include commodity-linked ETPs listed on stock exchanges worldwide including the New York Stock Exchange, Nasdaq, the American Stock Exchange, the London Stock Exchange, Euronext Amsterdam and Paris, Deutsche Boerse, Borse Italiana, Australian Stock Exchange, Johannesburg Stock Exchange, SWX Swiss Exchange, and Bombay Stock Exchange.

Earlier this year, an entire platform of short and leveraged ETPs was launched in both Europe and the U.S., adding a new dimension to the ETP market. Short ETPs enable investors to gain from falls in commodity prices, and leveraged ones facilitate gains from rising commodity prices, providing exposurewith 50% less capital. Interestingly, there has been substantial interest in these products, with flows into both short and leveraged products now accounting for 27% of the total value of inflows into ETPs since their inception.

So far in 2008, ETPs have been the most popular vehicle for investment in commodities, with total assets under management over $50 billion at the end of May and inflows amounting to over $9 billion for the same time period, compared to an overall inflow of $10.8 billion in 2007. Precious metals (primarily gold) hold the highest share in ETPs, but both agriculture and energy have emerged as very popular categories as well. Despite their recent growth, commodity ETPs only form a small part of global ETPs as a whole. For instance, U.S. ETP assets under management as of the end of May 2008 was $627 billion, whereas assets under management for commodity-linked ETPs stood at $37 billion, just above 5% of the total.

In addition to the ETPs where the underlying refers to futures, some ETPs are backed by physical holdings. These products are only available within the precious metals complex, and this is the only sector where these products actually have an impact on the physical market because allocated metal is removed from the market. It is worth noting that currently thereis net new demand for these physically-backed ETPs, which, as such, forms part of the demand side of the market balance. The holdings can equally be redeemed and just as easily be mobilized to provide physical supply to the market.

This type of structure has been especially popular for investors seeking an exposure to gold. The first physically backed gold ETF was launched in 2003. Since then, gold holdings have grown to a total of some 900 tonnes at the end of May across the 13 major physically backed ETPs we track. Total gold inflows into physically-backed ETPs totaled 251 tonnes in 2007, some 8%of total gold demand. The largest ETF is the SPDR ETF where gold holdings have reached just over 600 tonnes at the end of May, two-thirds of the gold interest held by these physically backed ETPs.

MTNs are a form of corporate debt financing and mostly encompass structured products. A structured product is generally a pre-packaged investment strategy that is based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances and/or foreign currencies, and to a lesser extent, swaps. Traditionally, MTNs were issued as senior unsecured debt securities paying a fixed coupon for terms of between 270 days and 10 years. Today, MTNs are "structured" in many ways, including new issues that can be prepared up to two years in advance, so that the notes can be offered as soon as funds require it or market conditions turn favorable. Securitizations are also issued as MTNs.

The commodity-linked MTNs are primarily structures linked to commodity indices. Though the vast majority of reported deals reference a broad selection of underlyings, there has been an unprecedented rise this year in structures linked to only agricultural commodities and precious metals in response to record prices in these sectors. Further, popular new offerings of notes linked to biofuels, emissions and freight indices reveal theincreasing sophistication among investors with respect to their use of structured note products to achieve targeted exposures.

As of the end of May, issuance of commodity-linked structures had reached over $6.5 billion. Just three years back, the commodity structured products sector was one of the smallest in terms of notional value compared to structured product issuance in the credit, equity, FX or inflation-linked markets. Now, commodities account for nearly one in three structures issued, and are the third highest category behind equities and interest rate-linked products. Nonetheless, commodity-linked structured products still form only 10% of the total structured products linked to all the different asset classes.

Our data are collected from the MTN-i website, where banks report the notes they have issued over the course of every month all across the globe. Unlike MTNs in the debt and equity world, where issues with terms of as much as 30 years exist, the usual life span of commodity-related issues are no more than five years, due to the illiquid nature of the market beyond this time horizon. However, the recent bull run in commoditieshas resulted in notes with durations of up to 10 years being structured.

Commodity indices based on baskets of commodity futures are one of the most versatile and popular vehicles for corporate investors to access the investment benefits of commodities. Index investments are long only, and all of their transactions relate to futures�there is no physical ownership of the underlying inventory involved.

An index investment replicates the buying of a forward position that is continuously rolled forward in time. The position is sold as it approaches expiry and the proceeds are used to buy forward again. One of the main issues surrounding this type of investment is that the index investors do not sell short, i.e., sell on the anticipation of a falling market and buy back at a cheaper price at a point in the future. As a result, index investments are susceptible to poor performance in falling or contango markets, or both.

Commodity indices comprise baskets of different commodity futures traded on an exchange. Different indices have different weightings in different markets, and there can be significant differences in the commodities tracked by each index. For example, the RICI tracks 36 commodities, while the DBLCI tracks only six. Of all the commodity indices, the S&P GSCI is by far the largest in terms of funds tracking its performance.

Investment via commodity indices has grown dramatically in the last five years, and this portion of the market is the largest in terms of assets under management. Total flows into indices are not reported, but U.S. commodity-linked mutual funds data provide a good barometer for overall flows into this category. Our data are collected via Bloomberg and include a comprehensive breakdown of the major funds. Assets under management were just under $18 billion at the end of the first quarter. Inflows year-to-date have been $330 million, a relatively moderate increasebut a sharp reversal from last year�s $1.4 billion outflow.

This article was first published in Futures Industry, the bimonthly magazine published by the Futures Industry Association (www.futuresindustry.org).