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.

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