17 8q0O esearch findings Do hedge funds and commodity funds affect commodity prices? The nature and size of hedge funds and commodity funds have changed in recentyears, making their influence on commodities markets potentially greater. Commodity prices have been extremely Several studies have found that commodi- volatile in recent years. For example, ty funds and hedge funds influence short- RECENT December 1996 wheat futures prices on the term commodity price trends. Gilbert (1994) Chicago Board of Trade went from a low of concludes that the rise in cocoa prices during VOLATILITY I $3.62 a bushel in early 1996 to a high of 1993-94 was due to fund investment. Robin COMMODITIES $6.23 a bushel, settling at $4.00 (Wall Street Adams of Resource Strategies, Inc. credits !VARKETS journal, 13 December 1996). Such volatility much of the rise in metals prices in 1994 to is larger than we have seen in recent years, fund activity (The Financial Times, 31 March PROBABLY raising the concern that the nature of wheat 1995). Continuing this line of inquiry, this 5ANNOT BE and other commodity markets has changed. note examines the recent behavior of hedge If so, strategies for dealing with price volatili- and commodity funds and assesses their TRACED TO ty need to be examined-particularly in impact on commodity price movements. developing countries, which often depend on The emergence of hedge funds and com- commodities for a large source of their export modity funds during the 1980s vastly FUNDS revenue. In 1992 primary commodities increased the capitalization available to specu- (including energy) accounted for 76 percent lators by pooling investment funds from of merchandise exports from Sub-Saharan wealthy individuals and pension funds. Africa and 47 percent of merchandise exports Several hedge and commodity funds have from all low- and middle-income developing assets of more than $1 billion, and they often countries (World Bank 1994). borrow money to increase their leverage. Hedge funds and commodity funds are one Because of their size and trading behavior, possible source of increased price volatility. these funds are alleged to follow-and These funds have received considerable atten- perhaps accentuate-price trends. When tion in recent years, and some analysts have these funds are directed to a single futures attributed movements in commodity prices to market, as was reportedly the case when the behavior of these funds. Speculators have George Soros's Quantum hedge fund invested always existed in commodity markets, and $10 billion in the currency market in 1992, they have long provided needed liquidity. In the impact is large. So far, however, such large recent years, however, the nature and size of investments have been concentrated in finan- this segment of the market have changed, cial futures and currencies. Commodity mar- making their influence potentially greater. kets are still bit players by comparison. FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY OF THE WORLD BANK NO. 29 FEBRUARY 1997 What are commodity and hedge Many institutional investors invest in com- funds? modity markets because it increases portfolio diversification. Studies have found that an index The distinction between commodity funds and of commodity prices is negatively correlated hedge funds is important. Commodity funds act with stock and bond prices. That finding sug- through commodity trading advisers and are gests that devoting a small portion of an invest- regulated in the United States under the 1974 ment portfolio to commodities lowers the riski- Commodities Exchange Act. Commodity funds ness of a bond or equities portfolio without are like mutual funds except that they hold significantly reducing the portfolio's expected futures contracts instead of equities or bonds. returns. Calculations by Goldman Sachs indi- The term commodity fund comes from the cate that the total return on primary commodi- legislation under which these funds are regulat- ties is comparable to that on equities ed rather than from their investments. In fact, (Wadhwani and Shah 1993). Commodity commodity funds have invested more in finan- futures contracts are held in the amount of the cial futures than in commodity futures. These portfolio (without leverage); funds not required funds expanded rapidly during the 1980s as for margin are invested in treasury bills. The investors sought access to futures markets and to total return, then, is the capital gain from hold- professional management. Commodity funds ing the futures contracts plus the interest gained may be either long or short-a long position on the treasury bills plus the gain (or loss) when Hedge funds and means that the fund has bought futures con- the futures contracts are rolled over into the next commodity funds tracts, while a short position means that the available contract as each contract expires. fund has sold futures contracts with the hope of Hedge funds are not required to report their can move repurchasing them at a lower price in the trading activity, so it is difficult to know what markets ... future-and often apply technical trading effect they have on futures prices. However, all strategies. U.S. commodity funds manage an trades on U.S. futures markets must be reported estimated $19 billion (Barrons, 30 October to the Commodity Futures Trading 1995). Commission, which reports net positions week- The term hedge fund is not legally defined ly and distinguishes among large speculators, and is therefore open to interpretation. Hedge small speculators, and hedgers. Hedge funds are funds are limited partnerships that hold or trade classified as large speculators. Some commodity a wide variety of assets including equities, funds are also classified as large speculators. bonds, real estate, and futures contracts. They Thus it is possible to identify movements in the are not restricted to long positions, so they can large speculative net position using hedge fund and often do hold short positions on these movements. investments. These funds may use futures to hedge a position in an underlying asset (say, by selling index futures to hedge an equity portfo- Evidence from coffee and lio), to increase leverage, or to establish a long or cocoa markets short position. Commodities traditionally have not been a Two recent examples from the coffee and cocoa major investment vehicle for hedge funds, but in futures markets provide evidence of large specula- 1993-94 hedge funds allocated a small portion tors' activities (Gilbert 1994, 1996). Plotting the of their funds to commodities. Because hedge net positions of large speculators, small specula- funds are very large, however, even this small tors, and hedgers for coffee contracts on the New allocation amounted to a sizable influx of money York Coffee, Sugar, and Cocoa Exchange from for the commodity markets. Industry sources October 1992 to March 1995 shows that large estimate that hedge funds manage about $100 speculators took large positions in December billion. Most hedge funds are based in the 1992 and again in the summer of 1993 (figure 1). United States, although an increasing number These speculators entered 1994 with a slightly are located in other countries. negative net position, but their position peaked at 20,000 contracts in April 1994. These positions prices. In practice, the large number of different declined after frosts hit coffee-growing regions in trading systems probably cancel each other out Brazil in June-July 1994, and by the end of 1994 with offsetting positions. they were back to zero. An examination of figures 1 and 2 helps The smaller buildup during the spring and explain the mechanism by which speculators summer of 1993 coincidecl with producer dis- affect commodity prices. As large speculators cussions that led to agreement on an export build up a long position, they bid up futures retention scheme in September. These positions prices. A long futures position by one group were liquidated as coffee prices rose on the con- must be offset by a net short position by anoth- fidence generated by the retention scheme. The er group. In the case of coffee and cocoa, it was increase in large speculators' net position in the hedgers who obliged. The same situation is 1994 followed declines in the U.S. bond market likely to occur in other commodities. The in February. As prices rose, speculators took increased net short hedging position requires profits on their positions, and by the June-July either that producers sell more of their output frosts their net positions were halved. forward or that consumers purchase less of their Looking at the same period for the cocoa requirements forward. In coffee and cocoa the market shows that large speculators' position second effect dominated, so that large specula- increased in July 1993, declined, and then built tors established their long positions at the up again in February 1994 (figure 2). expense of coffee roasters and cocoa grinders. By Investment in cocoa totaled about 30,000 con- bidding up futures prices, large speculators . .. but their size tracts ($300 million). encouraged consumers to shorten their cover, requires them to The increase in large speculators' net position But these higher futures prices translated into in both coffee and cocoa was almost entirely at higher cash markets. take positions that the expense of hedgers, with the position of are consistent with small speculators roughly constant over time. It market follows, then, that any changes in price levels or The impact on prices is fundamentals volatility during this period were due to the probably slight activity of large speculators. Large speculators cannot move in and out of the market quickly, Hedge funds and commodity funds have and they tend to take longer-term positions increased in size over the past decade, and they based on market fundamentals. Small specula- can move markets. But their size requires them tors are more likely to apply technical or trend- to take positions that are consistent with market following methods, which casts doubt on the fundamentals. They are unlikely to profit from influence of these techniques on commodity positions that are technically motivated or that Figure 1. Net coffee position on the New Figure 2. Net cocoa position on the New York Coffee, Sugar, and Cocoa Exchange, York Coffee, Sugar, and Cocoa Exchange, October 1992-March 1995 October 1992-March 1995 Thousands of contracts Thousands of contracts 20 Large speculators 30 spLargesecu ators I 0 20 0 speculato~~~~s rs I0Small speculators Hedgers -20 -20 ' Hedgers -30 -30 Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Oct Jan Apr Jul Oct Jan Apr Jul Oct ]an 1992 1993 1993 1993 1993 1994 1994 1994 1994 1995 1992 1993 1993 1993 1993 1994 1994 1994 1994 1995 Source: Gilbert 1995. Source: Gilbert 1995. run counter to trend-precisely because of their Further reading size-but they will profit if they correctly antic- ipate price movements induced by fundamentals Adarns, Robin G., Resource Strategies, Inc. Interview (as they did in coffee but not in cocoa). IT reported in The Financial Times, 31 March 1995. (as they did in coffee bUt not inf cocoa). It appears, though, that these funds may enhance Gilbert, Christopher L. 1994. "Commodity Fund Activity the price discovery process and accelerate price and the World Cocoa Market." London Commodity movements. They are accommodated by tradi- E L tional hedgers who take offsetting positions. . 1996. "Speculation, Hedging and Volatility in the Coffee Market, 1993-95." London Commodity Although it may be premature to conclude Exchange, London. that hedge funds and commodity funds have Wadhwani, S., and M. Shah. 1993. "Commodities and nor affected commodity prices, their impactV 0 Portfolio Performance." Goldman Sachs Portfolio probably has been less than is commonly Strategy. Goldman Sachs, London. believed. - nWorld Bank. 1994. World Development Report 1994: -Donald 0. M4'itchell Infrastructure for Development. New York: Oxford and Christopher L. Gilbert University Press. This DECnote was prepared by Donald 0. Mitchell and Christopher L. Gilbert (consultant) in the International Economics Department of the World Bank. DECnotes transmit key research findings to Bank Group managers and staff. They are drawn from the work of indi- vidual Bank researchers and do nor necessarily represent the views of the World Bank and its member countries-and therefore should not be attributed to the World Bank or its affiliates. DECnotes are produced by the Research Advisory Staff. We welcome your questions and comments; please e-mail thcm to the authors or to Evelyn Alfaro, RAD. Prepared for World Bank staff