Will the Long-only Index Funds Continue to Dominate?

As long as the long-only index funds maintain their dominate position in the futures market, we should see profitable opportunities to hedge our future crops.  Will the funds’ dominance continue?  Unfortunately, maybe not.

Since the mid-2000’s, the growth of these funds has provided us with attractive new ways to market our wheat.  At their peak, they held long contracts totaling almost 1.5 billion bushels in the Chicago soft red wheat futures market and currently hold long positions of around one billion bushels.  Every new long contract must be matched by a new short contract.  Hence, the funds’ huge new demand for long contracts required attracting many new short sellers.

Most short contracts have been traditionally sold by farmers and other hedgers who are holding stocks of physical wheat.  However, since the total soft red wheat crop averages less than 400 million bushels, the supply of short contracts from normal hedging didn’t come close to satisfying the funds’ demand.   The funds had to attract new short sellers by bidding futures prices up relative to cash prices, causing an abnormally negative basis, and increasing the market carry.  This made the hedging of all classes of wheat look more attractive.  We took advantage by selling more of our future crops with base-price (hedge-to-arrive) contracts.  Our coops earned higher profits by hedging and storing the wheat we sold to them and by delaying their sales to Portland exporters.

I recently read a new study by Dwight Sanders and Scott Irwin (“A Reappraisal of Investing in Commodity Futures Markets,” Applied Economics Perspectives and Policy, Autumn 2012) that examines the long-run profitability of the commodity index funds.  It concludes that their average long run returns have been essentially zero.

Abstract Investments into commodity-linked products have grown considerably in recent years. Unlike investments in equities, commodity futures markets produce no earnings; the source of returns is thus unclear. This paper examines returns to static long-only U.S. commodity futures investments over five decades and finds that returns to individual futures markets are zero, and the returns to futures market portfolios depend critically on portfolio weighting schemes. Historical portfolio returns are not statistically different from zero and are driven by price episodes such as that of 1972-1974. In other periods, portfolio returns are zero or negative. Overall, the case for long-only investment in commodities may not be as strong as that implied in some studies (e.g., Gorton and Rouwenhorst, 2006a). If so, the growth in long-only commodity investments may naturally subside and ease the policy debate regarding speculative position limits.

Low returns should eventually force the many pension funds and other investors who have put billions into these funds over the last decade to reconsider and shift their money to other assets.  The long-only funds were originally sold as a way to diversify portfolios.  Unfortunately for us, diversification by adding an investment that loses money on average isn’t a good strategy.

White Wheat Basis Update

Several months ago, I updated my data on the white wheat basis relative to Chicago  futures.  I believe the basis graph helps illustrate the effect of the long-only index funds on our basis.  The funds became dominant players in the Chicago futures market after 2005, but their early effects were masked by the two back-to-back years of Australian drought.

The Origins of the Long-only Index Funds

Several months ago, a friend handed me Matt Taibbi’s best selling book, Griftopia, and said, “read it and tell me what you think.”  I don’t normally read muckraking books written in a contemporary style that is both “over the top” and crude.  However, after skimming a couple of chapters, I realized that Taibbi is a bright guy with some interesting things to say.  I was surprised when I turned the page and came to Chapter 4—“Blowout: The Commodities Bubble”—in which Taibbi discusses the long-only index funds (see particularly pages 132-141) that now dominate the futures markets.

Taibbi makes two main points about the origins of the long-only index funds.  First, Goldman Sachs and other big banks obtain at least 17 semi-secret letters from the CFTC—starting in the early 1990’s—that allowed them to ignore the existing limits on speculative positions and begin a profitable campaign of selling long-only commodity index funds to investors.  Second, the “Uniform Prudent Investor Act of 1994” was passed.  This Act, “some form of which would eventually be adopted by every state in the union,” ended the prohibition on investing in commodities by pension funds and trusts.  In fact, they are now “duty bound to diversify as much as possible” and that mean including commodity funds in their portfolios.  As I was reading Chapter 4, I received a call from the bank that manages the financial assets of a small trust I’m involved with.  The bank wanted to increase the Trust’s holdings of commodity funds—even though the Trust’s main asset is wheat land.  I had wondered why commodity index funds were starting to appear in the Trust’s portfolio.  After finishing the chapter, I understood.

For those interested in the origins of long-only index funds, Chapter 4 of Taibbi’s book is worth a look.

Taking Advantage of the “Long-only Index” Funds?

In my last blog post, I explored how the dramatic growth of “long-only index” funds has affected the Chicago futures market.  These funds focus on worldwide inflation forecasts in making their investing decisions and have maintained their long positions irrespective of what is happening in the wheat market.  Accommodating this huge new semi-permanent demand for long positions requires attracting many more short sellers.  “Long-only index” funds must make the short positions of hedgers—farmers and grain handlers—more attractive and profitable, so they will hedge and store wheat that normally would be sold on the cash market. The higher the futures price is above the expected cash price (i.e. the more negative the basis), the more attractive hedging becomes.  This difference is the “fee” paid by the “long-only index” funds to maintain positions unrelated to the basic supply and demand for wheat.

After some worry, I’ve come to the conclusion that farmers can safely take advantage of this market distortion.  When futures prices are above expected cash prices, hedgers will normally make money and the “long-only index” funds will lose money.  Farmers will lose only if they must close out their hedge positions during a period when the funds are building their long positions and causing the basis to widen.

A New Way of Viewing Basis and Chicago Futures

Farmers in my area are increasing their use of base-price contracts to sell their current and (especially) future soft white wheat (SWW) crops.  Until 2007, the SWW basis (the Portland cash price of SWW minus the nearest Chicago futures price) fluctuated around 44 cents and was usually positive sometime during the early fall.  Since 2007, the basis has fluctuated erratically and spent most of the time in negative territory.  Since a strengthening basis (i.e., a basis that becomes more positive or less negative) adds to the net return from a base-price contract, understanding why the basis has been staying so negative has been a topic of considerable interest to my neighbors and me.

Two years ago, I discussed this issue in one of my first blog entries.

I explain why the basis should average 44 cents in this article.

In trying to understand why the basis has been negative for so much of the time since 2007, I’ve focused on the “convergence problem” problem in Chicago futures.  The futures price has often remained above the cash price of SRW wheat when futures contracts expire.  This isn’t supposed to happen and could contribute to the negative WW basis.  After several years of study, the Chicago Mercantile Exchange has failed to correct the “convergence problem” and I was beginning to wonder whether they really were serious about dealing with it.  However, I now think this lack of convergence is largely irrelevant in explaining our persistent negative basis.

My thinking changed in late October when I attended a U.S. Wheat Associates Board meeting in Minneapolis.  I attended a panel discussion including Mike Ricks, a senior manager for Cargill.  Listening to Mr. Ricks caused me to start thinking about basis in a new way.

A New Way of Thinking About Basis

The classic theory of futures markets argues that their main function is to facilitate hedging.  Normally, short hedgers (farmers and grain elevators) outnumber long hedgers (grain buyers and millers) so the market needs to attract long speculators to buy the extra contracts that short hedgers want to sell.

The Chicago wheat futures market began to change the way it functions  around 2006, when “long-only index” funds started building their positions in the wheat market.  These funds hold wheat futures contracts as a hedge against possible “food price inflation.”  They aren’t concerned about the current price of futures or short-run changes in the supply and demand for wheat—they just want to be long futures.  Shortly before each contract expires, they roll their positions to the next available contract month.

“Long-only index” funds now hold a huge and dominant position in the Chicago wheat futures market.  They hold contracts for at least 1.2 billion bushels—more than five times the size of this year’s soft red wheat crop.  Just as hedgers previously had to attract long-speculators to offset their net short positions in the market, the “long-only index” funds now need to attract short sellers to hold the other side of their huge long positions.

How do you attract new sellers willing to take short positions totaling 1.2 billion bushels?  Attracting the necessary supply of short-speculators might be difficult—since naked short speculation is risky when inflation is a worry.  However, new hedgers can also be attracted into the market to take the necessary short positions.  As the futures price rises above the cash price of wheat (i.e., the basis becomes more negative), hedging by owners of physical stocks of wheat looks more and more profitable—giving grain handlers and farmers an incentive to delay selling the crop so they can store and hedge more wheat.  Because hedgers hold a long position in the physical wheat, their short position in the futures market seems less risky than the position of a short speculator.  By being willing to take the other side of the futures contracts that the “long-only index” funds buy, hedgers have indirectly allowed the funds to accomplish their real desire—to hold physical wheat.

Can the Basis Return to Normal? 

One of the reasons hedging has looked attractive is because the basis has been unusually negative.  In calculating their expected profits, many hedgers are assuming that the basis will not stay unusually negative and will eventually return to “normal” levels.  Can basis return to “normal?”  What happens if basis narrows, i.e., cash prices rise (converge) to the level of futures prices?  If basis narrows, maintaining hedges will look less profitable and hedgers will start lifting their hedges by buying futures and selling their stored wheat.  This will cause the basis to widen again.  As long as the “long-only index” funds insist on maintaining their huge long positions, no big players in the market will be willing to sell contracts to exiting hedgers.  Futures prices will keep rising until hedgers stop wanting to buy futures — because hedging looks profitable again.  Hence, the situation may be unstable—the necessary amount of hedging will be done only if basis is expected to return to “normal,” but basis can’t return to normal if “long-only index funds” insist on maintaining their positions.  I now think I understand why the CME is having such difficulty forcing “convergence.”

Why Do Futures Prices Move with Cash Prices?

If “long-only index” funds are focused only on inflation and if hedgers are focused on the basis, what causes movement in the futures price and how are futures prices related to the supply and demand for cash wheat?  As argued above, the “long-only index” funds have caused an increase in U.S. wheat carryover and this has at times reduced exports.  As Mr. Ricks mentioned in Minneapolis, the index funds are causing the U.S. wheat carryover to reach levels that rival the size of the burdensome government stocks in past years.

Since about half of U.S. wheat is exported and must be priced competitively on the world market, the cash price of wheat is still predominantly determined by world supply and demand.  If the cash prices rise, the basis narrows and hedgers start lifting their hedges and buying futures.  This causes futures prices to rise along with cash prices and by enough to keep the necessary number of hedgers in the market.  Similarly, if the cash price falls, basis widens and hedging increases.  The resulting sale of futures contracts by hedgers causes futures to decline along with cash prices.

How Will All This End?

Mr. Ricks indicated in Minneapolis that Cargill had been giving lots of thought to the question, “How will all this end?”  I believe that until “long-only index” funds start liquidating their huge positions, the basis must remain wide and hedgers expecting the return of a “normal” basis may be disappointed.  When the “long-only index” funds start reducing their positions by selling their future contracts, the futures price will decline and the basis should initially narrow, i.e., become less negative.  Hedgers should then be able to liquidate their hedges at profitable basis levels.  As they do, they will sell their stored wheat and cash prices should decline along with futures.  If “long-only index” funds liquidate their positions quickly, the cash price of wheat could crash along with futures—as our large carryover stocks are dumped on the market.