Index and Big Spec Funds
In 2007, the Commodity Futures Trading Commission (CFTC) separated Index Funds from the “Speculative Fund” category on its weekly Commitment of Traders (COT) Report issued Friday after the close of the futures markets.
Index funds are a hybrid between a pure speculative account and a hedge account. Both are mutual funds, that is to say the fund managers manage a huge pile of investors’ money who hope the fund managers will make money trading futures.
Speculative funds are the “gun slingers” of the commodity futures world. They go for the big bucks, wherever they may be… corn, wheat, gold, silver, live cattle, treasury bonds… it does not matter. Each day is a new opportunity for the spec funds to trade for what they think is the easiest (least risk, quickest return) money.
Index funds are speculative also, but their choice of commodity futures is limited by their charter, which all investors read and understand the specific nature and mix of the commodities which make-up each index fund.
Generally speaking, an index fund is tied to a specific industry, such as ethanol production or steel making. Index funds trade specific stocks or commodities associated with an industry. For example, a soybean index fund will trade soybeans, soybean oil, soybean meal and perhaps some energy related commodities because biofuels and it takes energy to crush, store and transport beans, meal and oil. A soybean index fund might also trade futures on the Panamax Baltic Dry Freight Index which tracks the cost of ocean freight for 55,000 mt vessels used to transport beans, soy oil and meal. A bean index fund may also trade hog and poultry futures because hogs and chickens eat a lot bean meal. They may also trade interest rate futures because the cost of borrowed money is an expense of doing business.
It is noteworthy that the government (CFTC, IRS, SEC) regulations on index funds are less restrictive on index than pure speculation funds.
Index funds are very disciplined traders and they like to be long all the time because they are businessmen who have confidence their industry will make money and they want to be long the market because, as profits increase, so does demand for raw materials and that means higher prices. Also, businessmen know inflation must be a part of any investment plan and inflation means prices will go higher, everything else being equal. The Federal Reserve manages the money supply to achieve 2% annual inflation.
I never expect to see index funds to be short corn, wheat or beans. But what is important is to monitor is how large or how small their long position is, what is the trend of their position size and what are their record large open interest (503,937 contracts of corn 13 August 2010) and record small long positions (208,321 contracts on 25 April 2019). That is a difference of almost 3 billion bushels! But, they were long all the way the past 14 years.
Index funds are like battleships cruising the ocean… slow to change direction, big, powerful and nobody messes with them. Spec funds are the PT boats darting in-and-out of markets to grab a buck here and a couple more bucks there. On occasion, like the gunslingers of the Old West, big spec funds will gang up on a market to impose their will on it simply because they can do so to enhance their income.
The big specs ganged up on July corn in the spring of 1996 when they bought July corn every day for months as they attempted to run grain hedgers (specifically, grain elevators holding HTA contract hedges) out of money. It was the first time a corn futures contract traded above $4.00.
From the middle of March to May 13, 2019 the funds sold corn, wheat and beans. It was all fund selling because nobody was willing to risk enough money to buy everything the funds were selling until prices got way below the cost of production. The big specs were short a record large 334,262 contracts of corn on April 22nd of 2019 and the index funds were long “only” 208,821 contracts. By contrast, in January 2021, the big spec funds were long 435,357 contracts of corn and index funds were long 409,078 contracts. The price difference from May 2019 to January 2021 was a bit more than $2.00 per bushel on corn. That is why monitoring what these funds are doing is an important aspect of doing a good job of marketing your grain and beans.