Large Speculators in the Futures Markets

During the first month of the year some of you may have noticed some unusual price action in some of the Commodity Futures markets. An event that usually occurs at this time of year is called a Commodity Index Fund realignment. This is where Commodity Index Funds reposition their portfolios by changing the way the index is weighted. An index is simply a basket of Commodities that tracks individual or sectors of the Commodity markets.

Last year the Live Cattle and Feeder Cattle markets experienced a rally in price that took both these markets to all time highs. On the other hand, last year markets like Sugar were being sold off for most of the year. Both of these Commodities, along with others, will be in many of the Commodity Index Funds. To realign the weighting of an Index Fund the fund manager will reduce their number of contracts in markets like Live Cattle and Feeder Cattle due to the high prices and then possibly try and add more contracts of the lower priced Sugar market to their portfolio. Doing this can create some volatility in the markets as they exit and enter their massive positions.

This year was no exception. During the first week of trading this year Sugar made a move to the upside in one minute in excess of $625 per contract. Mind you, the average daily range for Sugar is approximately $380. Coffee had a very strong rally as well for the first week of the new trading year. Cocoa had a very large up day as well that far exceeded its average daily range. Live Cattle and Feeder Cattle have been selling off since December with the appearance that the Index Funds were exiting some of their large long positions.

So what are these Commodity Index Funds and how are they different from a Hedge Fund?

A Commodity Index Fund is a fund whose assets are invested in financial instruments based on or linked to a Commodity Price Index. In just about every case the index is in fact a Commodity Futures Index, however, there are some Spot Market Indexes.

To get an idea of what these Commodity Indexes are like think of the Dow Jones Industrial Average Index. As traders, we cannot trade the Index itself, but we can trade the derivatives of it in the form of Futures, Exchange Traded Funds (ETF’s), Options or the Stocks in the Dow Jones. The Commodity Indexes are no different than Stock Indexes except that they have different products making up the index.

A Commodity Index Fund simply creates products that we can trade these cash Indexes from. Some companies that create these products (and there are many more) are:

• Pimco Real Return Strategy

• Barclays

• JP Morgan

• iShares S&P GSCI – Goldman Sachs Commodity Index Funds

Some names of ETF’s these institutions issue are USO, GLD, SLV, COW and many more.

A Commodity Index Fund is a fund which either buys and sells Futures to replicate the performance of the index, or sometimes enters into Swaps (Physical Commodity Transactions) with investment banks who themselves then trade the Futures. This allows investors the chance to participate in the Futures markets by buying ETF’s issued by these institutions.

Since these institutions are selling you shares of ETF’s, they use the Futures markets to hedge their risk of the shares they sold you. These institutions are almost always net long the Futures markets. These types of ETF’s are generally passively managed trying to just track the Commodity Index and not trying to beat the indexes.

Commodity Index Funds are generally not directional style investors. They tend to be net long as a hedge.

The other type of fund you hear about in the Futures markets is a Hedge Fund. While the name implies hedging they rarely are doing that anymore. Hedge Funds are directional style traders placing bets on both the Buy side and the Sell Side of the Futures markets.

A Hedge Fund pools capital from a number of high net worth investors. Hedge funds invest in a diverse range of markets and use a wide variety of investment styles and financial instruments. Hedge Funds are not allowed to solicit the general public for investing purposes. This allows them fewer restrictions and generally less regulatory oversight issues.

Hedge Funds are most often open ended funds. Investors can make monthly and quarterly withdrawals. A Hedge Fund’s value is calculated as a share of the fund’s net asset value, meaning that increases and decreases in the value of the fund’s investment assets are directly reflected in the amount an investor can later withdraw. Like other managed investments, there are investment expenses using a Hedge Fund as well and these must be factored into the net asset value.

Hedge Funds have become so large they can impact Futures prices for long durations (trends).

These are just two examples of large market participants who can easily impact market prices and volatility. The Commodity Index Funds are known for distorting prices during their re-weighting of their portfolios at the beginning of each year, but both the Commodity Index Funds and Hedge Funds have monthly rollovers called “The Goldman Roll.” This is the period where these large investors must rollover their expiring Futures contracts. This event occurs the month preceding an expiration of a Futures contract. They will rollover on the 5th business day to the 9th business day, each day rolling over a percentage of their portfolio.

This is why you see open interest in the Futures markets roll before volume does.

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