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Index Investing Did NOT Spike Price; BRENT FELL

Emerging Markets, the Dollar and the Fed

Voting with Their Feet

Getting Grim For Gold Miners?

Looking Back To Look Ahead

Index Investing Did NOT Spike Price; BRENT FELL

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Maybe the verdict is still undecided for some, but it is hard to look at the evidence and still be questioning the idea that index investing drives underlying commodity prices.   Now that the commodity index rebalance is over and the shift between WTI and Brent is behind, we can examine the impact.  As I mentioned in a prior blog post, Not ALL Weights are EQUAL: Why Brent isn’t Heavier than WTI, there has been a dramatic move out of WTI and into Brent since 2011.  Below is the table:

Source: S&P Dow Jones Indices.
Source: S&P Dow Jones Indices.

If one follows the logic that prices increase based on index investing, then one would have witnessed falling WTI prices and rising Brent prices.  However, that is not what happened. 

Source: S&P Dow Jones Indices. Data from Jan 2011 to Jan 2014. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.
Source: S&P Dow Jones Indices. Data from Jan 2011 to Jan 2014. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance.

Notice 3 out of 4 years when the index weights were increasing in Brent, the return over the rebalance period was negative.  Also notice that in 2 of 4 years when the index weights were decreasing in WTI, the return over the rebalance period was positive.

Supply and demand should be unaffected by commodity futures investing since there is no physical delivery from commodity futures investing.  Along with the simple example over the rebalance, there are fundamental stories that demonstrate a disconnect between money flow and price. For example, Brent recently fell pressured by incremental increases in Libyan oil supply and expectations that Iranian crude will return to market.

Another simple argument is as follows: trading, production and open interest stats are similar for crude oil and natural gas where futures trading volume is several times larger than production or consumption.  Sometimes oil prices are up while natural gas is down, so how can futures trading be driving price of oil up while gas, with same trading stats, is down? (Nat gas may be down from fracking technology increasing supply.  A supporting comment is at http://www.econbrowser.com/archives/2012/04/a_ban_on_oil_sp.html with a follow up at http://www.econbrowser.com/)

There is a helpful summary of research studies on the topic of futures trading versus spot prices, which states that currently, there is no clear evidence of futures trading driving spot prices. An article on Vox by Lutz Kilian was based on his paper, “The Role of Speculation in Oil Markets: What Have We Learned So Far?” He co-authored the paper with Bassam Fattouh and Lavan Mahadeva. The article neatly summarized the results of a number of studies on the topic and concluded that the literature has shown that the presence of index funds has, if anything, been associated with reduced price volatility. (This is since long-only investors provide insurance to producers, hence reducing price volatility from the supply side) They found that the existing evidence is not supportive of an important role of speculation in driving the spot price of oil after 2003. Instead, there is strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals, rather than the financialization of the oil futures markets.

Another research piece on the link between commodity futures investing and spot price can be found at http://docs.edhec-risk.com/ERI-Days-Asia-2012/documents/Long-Short_Commodity_Investing.pdf.  The 2009 Staff Report by the U.S. Senate Permanent Subcommittee on Investigation argues that commodity index traders were disruptive forces, driving prices away from fundamentals. If established, this would support calls for an increase in transparency, position limits and margins to curb excessive speculation, and it is hoped – volatility. Since then, the claim that the financialization of commodity markets is responsible for the observed volatility in commodity prices has been the subject of an intense academic debate – the overwhelming conclusion of which has been that it is not possible to empirically link investments in commodity futures and commodity futures prices. (See for Irwin and Sanders (2011) for a recent review of the evidence at Irwin, S., and D., Sanders, 2011, Index funds, financialization, and commodity futures markets, Applied Economic Perspectives and Policy, 1-31.)

The Edhec paper also studies whether the observed financialization of commodity futures markets (as evidenced by the increase in the long, as well as short, positions of speculators over time) has led to change in the conditional volatility of commodity markets or to changes in their conditional correlations with traditional assets. Their results find no support for the hypothesis that speculators have destabilised commodity prices by increasing volatility or co-movements between commodity prices and those of traditional assets. Interestingly, this conclusion holds irrespective of whether speculators are labelled as “non-commercial” in the CFTC Commitment of Traders report or “professional money managers” (i.e., CTAs, CPOs and hedge funds) in the CFTC Disaggregated Commitment of Traders report. Thus their analysis does not call for a change in the regulation relating to the participation of professional money managers in commodity futures markets.

One last simple example, beyond oil, that commodity futures investing is not driving prices is from the summer of 2012.  According to Barclays Capital, commodity index flows were negative approximately $5-6 billion in 2012, but S&P GSCI Grains was up between 30-50%. Why? There was a major drought that destroyed the crop yield. The yield was worst for soybeans from the crop rotation out of the soil, which had the highest return not only from the low supply but from the relatively inelastic demand due to lack of substitutes for soy products.

 

 

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Emerging Markets, the Dollar and the Fed

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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The talk that QE 1-2-3 may end sparked predictions that the U.S. dollar’s FX value will rise in 2014 and that this will, in turn, hurt emerging markets.  There are risks in emerging markets, as there are in all markets, but the risks stemming from the expected end of QE 1-2-3 seem to be overblown.  While here at home the Fed’s primary concerns are employment and inflation – these are embodied in the laws that created the Fed – the central bank recognizes that financial damage abroad echoes loudly back to the US economy.  The winding down of QE 1-2-3 will raise interest rates somewhat and will be accompanied by improvements in the US economy.  While both these factors are likely to strengthen the dollar, stronger US domestic demand will be a plus for emerging markets.

However, the real action resulting from a stronger dollar is likely to be in the emerging markets, not in the Fed’s board room. The strengthening dollar, along with higher interest rates, will put downward pressure on emerging market currencies. Further borrowing by emerging markets countries, especially in dollars, will become more expensive. The stronger dollar will lower dollar denominated returns to investing in emerging market equities and may also dissuade some investors.

Other factors will offset some of the pressures from the rising greenback. For companies based in emerging markets, when the local currency falls exports priced in the local currency become more competitive while exports priced in dollars (many natural resources) generate larger local currency revenues. On the debt and fixed income side, many emerging market central banks remember the Asian currency crisis of the late 1990s, hold large foreign reserves and can withstand pressures for devaluations and the rising costs of dollar0denominated debts.  The appearance of local bond markets in some developing nations means less borrow in dollars or euros and more debts in their local currency.

For investors looking beyond the US all this is a reminder to do one’s homework.  The factors mentioned here – interest rates, the dollar, and the extent of local currency borrowing or local bond markets, and whether exports are priced in dollars or something else – all matter. And they all vary from market to market; in some emerging markets a stronger dollar might be a reason to invest.

Lastly, as usual there is no guarantee that an end to QE 1-2-3 will lead to a higher dollar.  The chart of the Fed’s Broad Trade Weighted Index of the dollar leaves the next move far from clear.Not Yet a Dollar Revival

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Voting with Their Feet

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Tim Edwards

Managing Director, Index Investment Strategy

S&P Dow Jones Indices

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Despite superb returns for the equity markets across the developed world, 2013 was a tough year for active managers.  While the average hedge fund recorded fairly solid gains over the year, such performance paled in comparison to the rampant equity markets.  It was also a year that saw historic lows for the potential returns available from the expert selection of securities.  By some measures, it was the toughest year for stock pickers in decades: rarely in history did the average stock deviate so little from its peers, or from the market1.  The average dispersion between S&P 500® stocks over the twelve months of the year was just below 5%, which is the lowest value across the 23-year data set we’ve collected:

Average S&P 500 monthly dispersion

Source: S&P Dow Jones Indices, as of January 2014.

In such circumstances, the relative value of active management in the equity markets is constrained.  Simply put, accurate bets deliver less alpha. We recently predicted that assets in broad-based index trackers (ETFs in particular) would grow or have already grown larger than the entire hedge fund industry.  December’s numbers are now in for both industries2, and it seems that investors have been voting with their feet in favour of our prediction.  With the current lack of opportunities facing active managers, who can blame them?

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1. Of course, there were plenty of individual equities that recorded stellar or catastrophic performances. The point is that on average such instances were less commonplace – and less dramatic – than has historically been the case.

2. ETFs assets grew around 2% in December (according to Blackrock)

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Getting Grim For Gold Miners?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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If you are worried that gold prices are falling, the prognosis could be much worse for gold miner stocks. Although many investors believe the performance of gold miners is just like the performance of gold, this is not quite the case.  If investors look at correlations alone to determine they are getting their gold exposure through gold miner stocks, they are missing a big part of the picture.

The historical correlation of monthly returns between the S&P GSCI Gold (gold) and the S&P Global BMI Gold (gold miner stocks) from Jan 1995-Dec 2013 was 0.78, though it has ranged from 0.68 to 0.90 when looking at 3-year rolling periods and it is at its highest now.

GoldGoldMinerCorrel

So when analyzing the relationship between gold and gold miner stocks, from that perspective, it looks strong – but is potentially deceptive. 

There are influences on gold miner stocks that are less related to gold.  Generally the management of the companies aims to maximize shareholder value where decisions may be in or out of line with the gold price.  For example, decisions on dividends, debt/equity ratios, hedging out the price of gold or switching the metal they are actually mining may drive the stock price.  Sometimes even stocks that are classified as gold miners may have a greater percentage of revenue coming from other metals.

During the aforementioned period (Jan 1995-Dec 2013,) the S&P GSCI Gold returned 212.8% versus a loss for the S&P Global BMI Gold of 36.1%.

Gold Gold Miner CumRet

Why is this? The losses of the gold miners are so much bigger in the negative years for gold and not as positive in the positive years for gold. On average when gold lost in a year, it lost 12.1%, while gold miner stocks lost 27.7%.  When gold gained in a year, on average it returned 14.4% but gold miner stocks were only up 12.8%.

Gold Gold Miner Returns

Also, the annualized volatility of the gold miner stocks is 37.1%, double that of gold at 16.7%.

Gold Gold Miner Volatility

Although there have been years with positive gold returns and negative gold miner stock returns, there has never been a negative year for gold with a positive gold miner stock return. So, a falling gold price could be a bad sign for the gold miners.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Looking Back To Look Ahead

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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In terms of fixed-income investing, 2013 is a year for the history books. Consequently, the question of what will 2014 bring for the fixed income investor arises. Some significant understanding of future fixed-income investing can be inferred from the recent past. The equity market had a very successful 2013 as the S&P 500 Index returned 29.6% for the year. Year-to-date, the stock market is down 0.38%, though we’ve only had a few trading days so far in 2014. For fixed income investments, yields have been on the rise going into the New Year and there are questions of the declining benefits of Fed stimulus, the timing of the tapering, and improving economics measured by jobs, manufacturing, and housing. This begs to question how much volatility equity and fixed income investments may experience.

In order to get a comparison between the two asset classes, the chart below looks at the daily total return of the S&P 500 Index and S&P Dow Jone’s fixed income indices over the past five years. The yearly standard deviation or volatility of daily returns for the S&P 500 has declined since the 2008 financial crisis, though with a 2013 volatility of 0.69, it is still higher than any of the fixed income indices. Treasury and senior bank loans, as measured by the S&P/BGCantor US Treasury Bond Index and the S&P/LSTA U.S. Leveraged Loan 100 Index, were the two fixed income indices whose volatility declined in 2013 to -0.147 and 0.056 respectively. The yields of indices may have started last year and ended this year rather close to each other with U.S. Treasuries, U.S. agencies, and investment grade corporates 30 to 50 basis points wider than they were at the start of the year. U.S. high yield and senior loans were tighter by 18 and 64 basis points, respectively. Given all the press that municipal bonds had received regarding Puerto Rico and Detroit throughout the year, it comes as no surprise that the S&P National AMT-Free Municipal Bond Index ended the year 100 basis points wider than it did at the start of the year when it was at a 3.06%. The S&P National AMT-Free Municipal Bond Index’s volatility rose 0.08 in 2013 to 0.206 from 2012’s level of 0.126. The S&P U.S. Issued Investment Grade Corporate Bond Index was not far behind municipals with an increase of 0.05, while the S&P U.S. Issued High Yield Corporate Bond Index’s volatility rose by 0.03 to 0.181.

Credit stories will continue to be an important factor in 2014 along with the changes in rates. With lower volatility to equity and a more predictability of returns, investors should take the volatility of the differing fixed income products compared with equity into consideration as they invest with the differing asset classes.

Looking Back To Look Ahead
Looking Back To Look Ahead

The posts on this blog are opinions, not advice. Please read our Disclaimers.