The Financialization of Commodity Markets

The Financialization of Commodity Markets

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The Financialization of Commodity Markets Investing during Times of Transition Adam Zaremba

THE FINANCIALIZATION OF COMMODITY MARKETS Copyright Adam Zaremba, 2015. Softcover reprint of the hardcover 1st edition 2015 978-1-137-46557-3 All rights reserved. First published in 2015 by PALGRAVE MACMILLAN in the United States a division of St. Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-49959-5 ISBN 978-1-137-47639-5 (ebook) DOI 10.1057/9781137476395 Library of Congress Cataloging-in-Publication Data Zaremba, Adam, 1985 The financialization of commodity markets : investing during times of transition / Adam Zaremba. pages cm Includes bibliographical references and index. 1. Commodity exchanges. 2. Commodity futures. I. Title. HG6046.Z37 2014 332.63 28 dc23 2014039897 A catalogue record of the book is available from the British Library. Design by Newgen Knowledge Works (P) Ltd., Chennai, India. First edition: April 2015 10 9 8 7 6 5 4 3 2 1

To my brilliant and beautiful wife Patrycja, who deserves all the credit

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Contents List of Illustrations Introduction ix xv 1 Asset Allocation in Commodity Markets 1 2 Passive Investment Strategies in Commodity Markets 9 3 Active Investment Strategies in Commodity Markets 47 4 Financialization of Commodity Markets 101 5 Performance Measurement of Commodity Investments 159 6 Commodity Investments in Financialized Markets a Study 189 Conclusions 209 Notes 211 Bibliography 215 Index 247

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Illustrations Figures 2.1 Production of grain and trading with grain futures in the United States 11 2.2 Cotton production and trading with futures contracts in the New York Cotton Exchange from 1871 to 1897, 2002 12 2.3 Global volume of trading with futures and options in the years 1998 2013 (million units) 14 2.4 Average annualized returns to spot commodities and collateralized commodity futures from 1959 to 2004 2012 16 2.5 Commodity excess returns and roll returns, December 1982 May 2004 19 2.6 Rolling futures contracts in the elder generation of indices of the commodity markets 23 2.7 Rolling futures contracts in the younger generation of indices of the commodity markets 24 2.8 Rolling futures contracts for indices that provide exposure to the entire forward curve 25 2.9 Risk premium according to the normal backwardation theory 31 2.10 Performance of the commodity market indices during the period from 1998 2014 (rebased indices August 1998 = 100) 42 2.11 Average annual rate of returns and standard deviations in the commodity market 1998 2014 42 3.1 AUM of the managed futures industry in the years 1980 2013 (billion USD) 49 3.2 Division of futures contracts investment strategies 57 3.3 Moving average an example 59 3.4 Sample buy and sell signals based on moving average 59 3.5 Comparison of moving averages 60 3.6 Intersection of moving averages as a transactional signal 62 3.7 Breakout strategies for sample quotations 63 3.8 Head and shoulders pattern on the sample graph 64 3.9 Shape of Japanese candlesticks 65 3.10 Bear market truncation on the sample graph 66 3.11 RSI oscillator for sample quotations 67 3.12 Relative value strategies 68 3.13 The diversification of portfolios of futures and stocks 72 3.14 Classification of managed futures indices 80

x Illustrations 3.15 Managed futures indices from December 1999 to October 2010 86 4.1 Notional outstanding amounts of OTC forwards and swap instruments in the world in the years 1998 2014 (USD million) 104 4.2 Notional outstanding amounts of OTC forwards, swap instruments, and options in the world in the years 1998 2014 (USD million) 104 4.3 Market value of OTC derivatives in the world in the years 1998 2014 (USD million) 105 4.4 Number of open positions in and trading volume of commodity futures contracts in the years 1993 2014 (million) 105 4.5 Share of instruments based on commodities in the global derivatives market (%) 106 4.6 Ratio of the volume of futures contracts to the number of open positions on the cereals markets in the years 2000 2011 107 4.7 Percentage of futures transactions in the cereal market made via electronic platforms (2004 2011) 108 4.8 Non-commercial investors in the CBOT wheat market 109 4.9 Non-commercial investors in the WTI crude oil market 109 4.10 Non-commercial investors in the COMEX copper market 110 4.11 Non-commercial investors in the COMEX gold market 110 4.12 Non-commercial investors in the NYMEX natural gas market 111 4.13 Market Composition, Open Interest, and the Price of Oil 111 4.14 Structure of the investors in the commodity markets in the years 1990 2012 112 4.15 Percentage of open positions held by the index investors in the years 2004 2011 113 4.16 Cumulative index flow and S&P GSCI Agriculture and Livestock Excess Return Index, January 2006 October 2009 117 4.17 Copper prices against net positions of the noncommercial investors 117 4.18 Changes in the prices of selected commodities in the years 2000 2011 (percent) 120 4.19 Traded vs. non-traded (RIND Index) commodity prices (index, rebased end-2007=100) 120 4.20 Linear correlation coefficient between WTI oil and soy in the years 1988 2011 (annual periods, daily rates of return) 123 4.21 Linear correlation coefficient between WTI oil and cattle in the years 1988 2011 (annual periods, daily rates of return) 123 4.22 Linear correlation coefficient between WTI oil and copper in the years 1988 2011 (annual periods, daily rates of return) 124

Illustrations xi 4.23 Linear correlation coefficient between WTI oil and cotton in the years 1988 2011 (annual periods, daily rates of return) 124 4.24 Average correlations of indexed and off-index commodities, 1973 2011 125 4.25 Volatility of stock prices and correlation coefficient in the commodity markets in the years 2000 2011 127 4.26 Inflation and its variance in the United States in the years 1973 2011 128 4.27 Sources of profit in the commodity futures market in the years 1970 2010 (percentage points) 129 4.28 Cumulative returns on strategies based on term structure in financialized and non-financialized markets 130 4.29 Cumulative returns on strategies based on momentum in financialized and non-financialized markets. 131 4.30 Correlation coefficient between commodities and equities in the period from December 1994 to June 2011 144 4.31 Correlation coefficient between commodities and bonds in the period from December 1994 to June 2011 145 4.32 Average monthly rate of return on CISDMCAW* rolled over five-year periods in the years 1984 2011 148 4.33 Average monthly rate of return on CISDMCEW* rolled over five-year periods in the years 1984 2011 148 4.34 Average monthly rate of return on BARCCTA* rolled over five-year periods in the years 1984 2011 149 4.35 Average monthly rate of return on MLMCITR rolled over five-year periods in the years 1984 2011 149 4.36 Average monthly rate of return on MLMCI rolled over five-year periods in the years 1984 2011 150 4.37 Cumulative arithmetic rates of return on individual components of profit on the SPGSCI index in the period from January 1970 to June 2011 152 4.38 Cumulative arithmetic rates of return on individual components of profit of the JPMCCI indices in the period from December 1991 to June 2011 153 4.39 Cumulative arithmetic rates of return on individual components of profit of the DJUBS indices in the period from December 1991 to June 2011 154 4.40 Cumulative arithmetic rates of return on individual components of profit of the SPGSCI indices in the period from December 1991 to June 2011 155 4.41 Cumulative arithmetic rates of return on individual components of profit of the UBSCMCI indices in the period from December 1997 to June 2011 156 4.42 Cumulative arithmetic rates of return on individual components of profit of the MLCX indices in the period from December 1991 to June 2011 157

xii Illustrations 5.1 Graphical representation of the Sharpe ratio 160 5.2 Security market line 165 5.3 Jensen s alpha 166 5.4 Treynor ratio 167 5.5 Measure by Modigliani and Modigliani 169 5.6 Graphical representation of GH1 170 5.7 Graphical representation of GH2 170 5.8 Conditional value at risk 174 5.9 Drawdown statistics 175 5.10 Graphical representation of RFR 179 5.11 Expansion of the efficient frontier due to the introduction of a new asset class to the universe of the available investments 181 6.1 Efficient frontier in the stock, bond, and commodity markets (expected return vs. standard deviation) 191 6.2 Efficient frontier in the stock, bond, and commodity markets (expected return vs. MVaR) 192 6.3 Efficient frontier in the stock, bond, and commodity markets (expected return vs. standard deviation) with parameter a = 0.37 p.p. 196 6.4 Efficient frontier in the stock, bond, and commodity markets (expected return vs. MVaR) with parameter a = 0.37 p.p. 197 6.5 Efficient frontier in the stock, bond, and commodity markets (expected return vs. standard deviation) with parameter a = 0.185 percent 199 6.6 Efficient frontier in the stock, bond, and commodity markets (expected return vs. MVaR) with parameter a = 0.185 p.p. 199 6.7 Efficient frontier in the stock, bond, and commodity markets (expected return vs. standard deviation) for the rising correlation scenario 202 6.8 Efficient frontier in the stock, bond, and commodity markets (expected return vs. MVaR) for the rising correlation scenario 202 6.9 Efficient frontier in the stock, bond, and managed futures markets in the expected return and standard deviation framework 205 6.10 Efficient frontier in the stock, bond, and managed futures markets in the expected return and MVaR framework 205 Tables 2.1 Global volume of trading with options and futures contracts in the world in 2013 broken down into the underlying instruments 13 2.2 Global volume of trading with options and futures contracts in the world in 2013 by regions 13

Illustrations xiii 2.3 The world s largest markets of futures and options in terms of trading volume in 2013 14 2.4 Historical excess returns, December 1982 May 2004 17 2.5 Simulation of diversification returns for different numbers of instruments in the portfolio and for different volatility and correlation 22 2.6 Weights in the selected commodity indices in year 2014 38 2.7 Commodity market indices 40 3.1 AUM of managed futures by a subclass between the fourth quarter of 2014 and the second quarter of 2014 50 3.2 Definitions of the CTA, CPO, FCM, and IB 51 3.3 Comparison of the tasks and responsibilities of CTA and CPO 52 3.4 Levered and delivered returns by hedge fund strategy, 1997 2001 74 3.5 Characteristics of the managed futures indices 85 3.6 Correlations between managed futures indices from December 1999 to October 2010 87 3.7 Rate of return on managed futures indices from December 1999 to October 2010 88 3.8 Rebalancing bias computational example 95 3.9 Biases on the databases and CTA indices and the proposed measures for reducing or eliminating them 97 4.1 Performance of technical analysis in the light of previous studies 139 4.2 Indices used in the correlation analysis 143 4.3 Correlation coefficients between the stock market and the commodity market in the period from 1991 to 2011 145 4.4 Correlation coefficients between the bond market and the commodity market in the period from 1991 to 2011 146 4.5 Indices used in the study of the effectiveness of technical analysis 147 4.6 Rates of return on active and passive indices of futures funds in the years 1980 2011 150 4.7 Indices used in the study of changes in the sources of returns in the commodity markets 151 4.8 Sources of return on the SPGSCI index in the years 1970 2011 152 4.9 Sources of return on the JPMCCI indices in the period from December 1991 to June 2011 153 4.10 Sources of return on the DJUBS in the period from December 1991 to June 2011 154 4.11 Sources of return on the SPGSCI indices in the period from December 1991 to June 2011 155 4.12 Sources of return on the UBSCMCI indices in the period from December 1997 to June 2011 156

xiv Illustrations 4.13 Sources of return on the MLCX indices in the period from December 1991 to June 2011 157 5.1 IR for negative rates of return a calculation example 163 6.1 The indices used in the portfolio optimization with commodities and futures contract funds 190 6.2 Stocks, bonds and commodities basic statistics 191 6.3 Mean-variance spanning test with passive investment strategies in the commodity markets regression approach 192 6.4 Mean-variance spanning test with passive investment strategies in the commodity markets simulations 193 6.5 Stocks, bonds, and commodities descriptive statistics for a = 0.37 p.p. 195 6.6 Mean-variance spanning test for the commodity market with parameter a = 0.37 p.p. 197 6.7 Mean-variance spanning test with passive investment strategies in the commodity markets with parameter a = 0.37 simulations 197 6.8 Stocks, bonds, and commodities descriptive statistics for a = 0.185 percent 198 6.9 Mean-variance spanning test for the commodity market with parameter a = 0.185 p.p. 200 6.10 Mean-variance spanning test with passive investment strategies in the commodity markets with parameter a = 0.37 p.p. simulations 200 6.11 Mean-variance spanning test for commodities for the growing correlation scenario 203 6.12 Mean-variance spanning test with passive investment strategies in the commodity markets for the scenario of modified interdependence between the asset classes simulations 203 6.13 Stocks, bonds and managed futures basic statistics 204 6.14 Regression-based tests of mean-variance spanning for managed futures 206 6.15 Mean-variance spanning test with active investment strategies in the commodity markets simulations 206

Introduction Since the publication of the paper titled Facts and Fantasies about Commodity Futures by Gorton and Rouwenhorst (2004), no other class of assets has gained as much popularity as commodities. Formerly classified as niche investment products, they have made their way into the portfolios of pensioners, students, and common investors. The level of activity of investors in commodity markets has been increasing at an impressive rate. According to the data of the Bank of International Settlements (BIS), the number of open items in commodity-related futures contracts has increased from slightly above 20 million in 1993 to almost 160 million 17 years later. The turnover did not fall behind. In 1993, the participants of the market completed transactions for about 40 million futures contracts, whereas in 2010, the amount was almost 600 million, which means that the volume had increased by as much as fifteen times. 1 The interest of investors ran parallel with the development of information and analytical products, as well as with the increase in the number of publications in the media and scientific press. Speculators in commodity markets have never been received well by politicians and citizens. While the majority of the academic world appreciate the benefits of the presence of speculators in commodity markets, such as the fact that they ensure liquidity, the very notion of the speculator holds negative connotations for the rest of society. The Collins Dictionary of English Synonyms mentions four synonyms for the word speculation : gamble, risk, gambling, and hazard (Szado 2011). However, the increase in speculative activity in the commodity markets had not provoked any fears until 2008, when the oil prices exceeded 100 USD per barrel. At that point, speculation transformed into excessive speculation in accordance with the Collins definition (2011), which states that excessive speculation occurs when the prices of commodities become painful for voters. While the organs of public administration have begun to inspect the functioning of commodity markets and the activities of speculators closely, there has been a revival in ideas for limiting the activity of speculators in commodity markets. High prices of commodities including oil in particular have resulted in the increased interest of the scientific world in the role of financial investors in commodity markets and their significance to the fixing of prices. The importance of the impact that investors have on the activity of commodity markets has been noticed. A great deal of emphasis was placed on the increase in the prices of food and energy, which threaten the functioning of

xvi Introduction entire societies in poorer parts of the world. However, relatively little attention was focused on the importance of the high increase in the speculative activity of the investors themselves. This book is an attempt to describe and explore in a complex manner how structural changes caused by the increased activity of financial investors on commodity exchanges have influenced investment conditions in the relevant markets. A particular emphasis was placed on the strategic allocation of assets within the investment portfolio and the benefits resulting therefrom. Therefore, the book is intended to bridge a significant gap in the literature on the subject. The analysis has been performed from the point of view of a global investor. Investments in commodity markets are relatively complicated. In contrast with the classic equity or bond markets, there is no simple method for getting exposition to a commodity market, and particular investment vehicles used for that purpose may differ significantly between one another. In addition, there is no single source of profit, but several independent and uncorrelated ones. What is more, there is no unambiguous data, and all available data is charged with numerous burdens. Finally, the investment performance measures laid out in the literature are not fully adjusted to the character of a commodity market. Apart from the analysis of the functioning of such measures, the assumed purpose required collecting complete information concerning the effects of the increased significance of financial investors. In the subject literature, the process of the increase in the significance of financial investors is usually referred to as financialization. All of the above-mentioned problems constitute the subject of this work. The effects of the increase in the significance of investors in commodity markets may potentially be multidimensional and, for example, related to the formation of price bubbles, change of market term structure, increase of correlation, or decline in the efficiency of selected investment strategies. Their presence, to a reasonable extent, may even entirely question the relevance of the practice of undertaking investments in commodity markets. The discussed issues are therefore considerably important especially for investors, both individual and institutional. The essential purpose of this work is to answer the question of whether, under the conditions of structural changes in commodity markets resulting from the increased significance of financial investors, investments in commodities remain relevant both as individual deposits and as a part of a larger investment portfolio, contributing to the increase of efficiency that is, to the improvement of the profit-to-risk relation. In other words, does investing in commodities still make sense in light of the fundamental changes to the markets? The book is divided into six chapters. Chapter 1 contains the definitions of basic notions related to the strategic allocation of assets in commodity markets. It also describes the definitions and classifications of assets used in the literature. Furthermore, the chapter contains the differentiation between the notions of benchmark and strategic or tactical asset allocation. It also presents an overview of investments in

Introduction xvii commodity markets, together with an indication of the ways in which one may gain exposition to them. Chapter 2 focuses on the characteristics and functioning of passive deposits in commodity markets, understood as investments in indices of commodity futures contracts. The history of development of the futures market is followed by an analysis of different sources of profits related to commodity futures contracts. It also presents key theories and hypotheses explaining the functioning of long-term positive return rates for investors in the commodity market. Next, the work concentrates on the review of publicly available indices of commodities, leading to the selection of the index that will represent this class of assets most reliably for the requirements of further empirical research. Chapter 2 concludes with a review of the literature related to the occurrence of risk-related bonuses in commodity markets, as well as to the relevance of their application in the case of optimization of an investment portfolio with regard to profit-to-risk relation. The subject matter under consideration in Chapter 3 is active investment in commodity markets, here understood as managed futures investments. As with Chapter 2, the history of the evolution of managed futures funds is discussed first, and it is followed by the characterization of the institutional base of their functioning. Then the basic methods of managing portfolios of managed futures funds are illustrated, together with a theoretical explanation of the occurrence of positive return rates in the case of active investments in commodity markets. Chapter 3 then focuses on the benchmarks of the managed futures branch, and the potential significance of the information that they carry. The purpose of these considerations is to select the relevant benchmark that could serve the requirements of further empirical studies. As in the case of the analysis of passive investments, Chapter 3 concludes with a review of the literature concerning the relevance of investments in the managed futures markets. Chapter 4 focuses on the phenomenon of financialization of commodity markets, that is, on the increasing importance of financial investors in commodity markets. Chapter 4 has two goals: first, to characterize and investigate the influence of the consequences of financialization on the conditions for investment in commodity markets. Five potential effects of the financialization phenomenon have been taken into account: formation of price bubbles, increase of correlation between particular commodities, increase of correlation between the commodity market and the equity market, change of market term structure, and decline in the efficiency of technical analysis, whereby the analysis takes the form of a review of the existing literature. The other goal is an attempt to quantify the significance of three phenomena that could have an essential influence on the conditions for investment in commodities: increase of correlation between the commodity market and the equity market, change of market term structure, and decline in the efficiency of technical analyses. Chapter 5 includes the presentation of tools for evaluating investments in commodity markets. Active and passive deposits on commodity markets,

xviii Introduction due to their character which is essentially different from traditional investments in shares and bonds require the application of nonstandard investment evaluation measures. Chapter 5 includes two parts. The first part characterizes the investment evaluation measures functioning in existing literature, with an indication of their defects related to the specific character of the commodity market. This is followed by a proposal of two new measures, which will be applied in the empirical analysis. The second part discusses the methodology of research concerning the statistical relevance of including commodities in the traditional portfolio, with shares and bonds. The sixth chapter of the book contains empirical research intended to verify the relevance of investment in commodity markets in two aspects: as an individual investment and as an element of a larger investment portfolio. The examination of the relevance of investment in commodities was conducted with the application of raw historical data, as well as after a modification of such data, intended to consider potential structural changes of commodity markets resulting from the increase of significance of financial investors. The book ends with the Conclusion, where the findings of the conducted research are summarized and the question of the relevance of investment in commodity markets is answered. Furthermore, there is an indication of directions for further research, which could potentially throw new light on the issues constituting the subject matter of this book.