Streetwise Professor

Index funds and pension funds are the most recent bêtes noir in the commodity speculation debate. These participants are primarily long, are supposedly relatively insensitive to price (which is an assertion, rather than something for which reliable evidence has been produced), and hence according to critics are driving up prices of oil and grain. And by “prices,” critics mean the prices of physical commodities that consumers buy.

These arguments fail to grasp important aspects of the operation of derivative and commodity markets, and ignore the benefits these market participants can reap from trading in the commodity markets.

The main error in the argument is that it does not recognize that there are multiple markets for commodities, some of which are markets for the physical commodity proper, and some of which are for commodity price risks. Derivatives markets serve the latter purpose, and fund investors almost exclusively restrict their activities to those markets, and hence affect only the prices for commodity price risks rather than the prices of commodities themselves.

Virtually all index investors and pension funds do not participate in any way in the physical market. If they are in futures, they roll their positions prior to delivery. If they gain commodity exposure through swaps, they are pure price takers, and even if their counterparties hedge some of the index exposure through the futures markets, these firms also roll prior to delivery and hence do not contribute any demand for physical commodities. Hence, they cannot affect—or in particular, elevate—the price of any physical commodity.

But, the critics reply, since these funds are buying, they HAVE TO make prices higher than they would otherwise be. In addressing this criticism, it is necessary to be precise and ask: what price? Clearly, all else equal, with more buying interest, the futures price will be higher than it would be without it (unless the supply of offsetting positions is perfectly elastic, as may be the case). But it is important to recognize that this buying raises the futures price relative to the expected spot price. Since index traders and index funds are likely uninformed, their buying does not systematically convey bullish information to the market, and hence does not affect the expected spot price; and if these trades have any information content, they should have an impact on prices, and this impact is beneficial.

By moving the futures price relative to the expected spot price, index/fund trading (a) does not elevate the prices consumers pay for physical commodities; and (b) affects the RISK PREMIUM embedded in futures prices, and hence the trend in the futures price for a particular contract up to the expiration date. In other words, the price that fund traders affect is the price of risk, not the spot price of oil or gas or corn.

In a Keynesian “normal backwardation” type model, in which speculators are not diversified and hence idiosyncratic risk affects futures prices, and hedgers are net short, the addition of new long speculators causes the futures price to rise relative to the expected spot price, reducing the discount in the futures price and the upward trend in the price. Their entry also displaces some other long speculators who find that the greater competition from the index/fund investors reduces the profits they earn from their trading. In this model, these other longs only participate if the futures price is below the expected spot price. Hence, as long as any of these traders remain, the futures price must remain below the expected spot price, but by a smaller amount. All that the entry of index funds does is replace one set of long speculators with another that bears the commodity price risk at lower cost, reduces the risk adjustment in futures prices, and therefore makes the net short hedgers better off. This is not Pareto improving—the displaced long speculators and some long hedgers are made worse off—but overall surplus rises because risk is borne at a lower cost. So, what’s the problem? None that I can see.

It is theoretically possible that that long index/fund participation can be so great that it completely displaces other long speculators. That is, fund trading causes the futures price to rise above the expected spot price, meaning that all other long speculators leave the market. Again, though—so what? This hurts those speculators and some long hedgers, but benefits short hedgers even more. (I should also add there is no evidence that this has in fact happened. There are still long speculators in the markets other than the index funds, so evidently they have not all been displaced.)

The theoretical possibility that participation of index/fund investors causes the sign of the risk premium to flip also points out that it is dubious to call these folks “speculators” in any event. They are really hedgers, in the very real sense that they are buying futures to reduce risk exposure. They are buying futures for diversification reasons—that is a risk reducing trade, and hence it is legitimately referred to as a hedge. They are not traditional hedgers, to be sure, but again—so what? Investors are people too. Why should they be denied the opportunity to use the commodity markets to reduce their risks? Why should they be considered inferior to other long hedgers who just happen to participate in the physical markets? Suspicion of these non-physical long hedgers seems to be an example of what Thomas Sowell once termed “the physical fallacy” in his excellent book Knowledge and Decisions.

Indeed, the presence of index/fund investors in the commodity markets serves to integrate the financial and commodity markets. This integration ensures that risks are priced consistently across the two markets. Indeed, the flow of funds from portfolio investors (who may include hedge funds too) from traditional equity and fixed income investments to commodity markets is likely a reflection of a mispricing of risks across these markets. In essence, this flow is serving to arbitrage away a differential in risk prices across previously segmented markets. Again—this is a feature, not a bug.

My work (with Martin Jermakyan) on electricity prices shows that incomplete integration can impose very large costs on hedgers. Electricity is probably an extreme case, but due to incomplete integration forward prices are substantially above expected spot prices. This is a symptom of inefficient risk pricing and risk allocation.

If all the markets are completely integrated, risk premia in commodity prices will be driven purely by the covariation between those prices and the market pricing kernel. The composition of market participants would be completely irrelevant. Barring one group from participating in the market would just open up a profit opportunity for somebody else without having the slightest effect on risk prices.

However, restricting the participation of portfolio investors may impede integration of the commodity, stock, and bond markets. In this case, risks will be priced inefficiently and risks and capital will be allocated inefficiently. Why is that considered desirable?

The main things to remember in this debate are: (a) since fund investors do not participate in the delivery market, they cannot be influencing physical market prices, except to the extent that by improving risk allocation they are making hedging more efficient and thereby beneficially affecting investment and stockholding decisions, and (b) the main effect of index/fund participation is to affect risk premia in futures prices (i.e., the relation between futures and expected spot prices), and in a way that improves the efficiency of risk allocation. Index/fund participation facilitates the integration of commodity and financial markets. This helps rationalize the pricing of risk. Again—a good thing.

The entire debate over speculation in commodity markets, at least the political side of that debate, is largely devoid of good economic reasoning. This goes in spades for the debate over the role of index funds and pension funds in the market. The “they buy therefore they drive up prices therefore they should be banned” syllogism is completely bogus. It is bogus because fund buying does not in the first instance drive up physical prices, and hence does not affect the price that we all pay at the pump. It is bogus because fund participation affects risk premia—the relation between futures prices and expected spot prices rather than spot prices or expected spot prices. It is bogus because it affects risk premia in a good way. It ensures consistent pricing of risk across markets and the efficient allocation of risks across markets.

Some people may be hurt by this flow of capital—but it is not the people that politicians are allegedly defending, such as individual consumers. Traditional speculators who earned rents in less-integrated markets are hurt. Long hedgers in markets dominated by short hedgers may be hurt, but their losses are more than offset by the gains of short hedgers and the fund investors themselves.

More generally, I have yet to hear anyone—anyone—present a credible case that there is a true (rather than pecuniary) externality that results from the entry of a new class of participants into the commodity markets. Absent such an externality, the free flow of capital across markets will have a beneficial effect, rather than a baleful one. Index and pension fund investors participate in the commodity markets because it improves their risk-return tradeoffs. This is a bad thing? Competition and the free flow of capital facilitates the efficient pricing of risk. This is a bad thing? These flows do not affect, let alone distort, the physical markets except insofar as improving the allocation of risk improves the efficiency of investment and inventory decisions. So this is a bad thing?

When one understands the very basic finance of index/fund participation in commodity derivatives, it is evident that restrictions on their participation in the market, either through position limits or (in the extreme) banning them altogether are extremely misguided. Extremely. Their participation should be encouraged, not limited. Derivatives markets are first and foremost markets for risk, and index/fund investors in commodities are just using those markets for the very purpose of managing risk. By doing so, they are improving the allocation of risk and its pricing across all markets—stocks, bonds, real estate, and commodities. They bear commodity price risk at a lower cost than others. This is unambiguously a good. Unambiguously. Will Congress understand this? Sadly, there is considerable room for doubt.