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Institutions ‘should beware commodity indices’

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SPAIN - Institutional investors were put into the dock on their approach to commodities indices, at the World Cup of Indexing Conference.

“If the institutional investor is a hammer, all investment problems are supposed to look like nails, and we force commodities into indices, for better or worse,” said commodity expert Howard Simons, who is a strategist to Bianco Research and president of Rosewood Trading, both US-based.

“We have seen widely divergent approaches to the construction of commodity indices, which indicates we have no a priori knowledge to construct one properly,” said.

All approaches, in Simons’ view, were no more than “ad hoc responses” to past performance as they seek to attract investment funds.

He thought that commodity index funds were handicapped because, among other reasons, that commodities tend to be mean reverting over time.

“Neither they nor anyone else can promise a long-term bull market in commodities due to the self-correcting nature of commodity price cycles,” he added.

He pointed out that just as indexation can produce absurdities in stocks, it can also produce “crowding effects” during the monthly roll. “What worked with $5bn may get awkward at $70bn, when everyone know the dates and quantities of the trade.”

This invited front running in his view.

Overall he warned about the care needed when investing in commodities, pointing out that in contrast to equities, fixed income and real estate, commodity futures are by design a “zero-sum game”.

“The cyclical and mean reverting nature of commodity prices and their observed declining constant dollar prices overtime should give pause to those seeking this as a source of return,” said Simons.

However, he said that petroleum markets may be an exception here, as crude oil is produced without replacement and there is no recycling, as there is with gold and other metals.

He pointed to the fact that higher commodity prices will encourage future production and discourage demand, which was a self-defeating strategy.

“We are in a self-fulfilling bull market at present wherein higher prices attract new funds. This is referred to as a ‘bubble’ in other walks of life.”

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