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Commodity Index Funds: Beyond the Rebalance

Every year around December, those of us in #coffee (and in the commodity industry in general) start talking about “the rebalance.” While the #rebalance can be particularly impactful, especially when one #commodity vastly diverges from the pack, #IndexFunds in general represent a major source of cash flow in coffee and other commodity markets. As such a significant force, it is important for us to understand how they work, and what impact they can have.

Aside from the annual rebalance, Index funds also impact the markets throughout the year via capital flows. In this article, we will examine why index funds are not always so popular, what an index fund is, how they influence commodity markets, and how to think about the rebalance.



Why Index Funds get a Bad Rap

First, index fund are “dumb money”. Note, they aren’t dumb people working there, in fact its often very talented people. However, unlike other market participants, such as the #commercials (the trade, roasters, etc), Index funds don’t particularly care about fundamentals, price action or making or losing money in a commodity.

Since, they don’t necessarily base their actions on price expectations from deep analysis of the markets there can be some resentment of these funds. Some market participants feel like index funds are distorting true values in a market. This is a bit unfair, because Index funds do serve the function of helping to connect retail investors to buying and selling commodities, and also the supply and demand for commodities as a sector.

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How impactful the index fund is on a market, will depend on the relative size of their position. We can see the positions of index funds through the supplemental version of the COT, also known as the CIT (Commitment of Index Traders). This breaks down positions into commercial (producers, traders, consumers and hedgers), non-commercial (spec/hedge fund) and Index Fund positions.


What is a Commodity Index Fund?

So we know why some people don’t like them, but before we should define exactly what an index fund is. A market index (as opposed to an index fund) aggregates prices into an index to get an objective measure of an entire sector or subsector. For example the Bloomberg Commodity Index (BCOM) aggregates commodity prices.

Index funds recreate these indices as an investment vehicle which allow investors to take positions in entire market sectors of their interest, from stocks, bonds, real estate, and even fine art pieces have index funds associated with them. An index fund reproduces what it would be like to invest in an index by buying a basket of the underlying securities.

In our case, we are concerned with commodity index funds. They provide exposure to commodities to their investors, and they do so by buying and maintaining portfolios of futures contracts.

The benefit to an investor of an index is that it provides broad market exposure rather than actively picking individual commodities. This is also why we call these funds “dumb money”, the capital flows are entering and leaving the market without regard to the particular commodity’s fundamentals.

However, the key to an index fund matching an index is in maintaining an equal exposure to each commodity. This requires active management, and an annual rebalance.

Understanding the Rebalance

Funds will have imbalance in their portfolio as exposure to some commodities increases while it decreases to others because of price oscillations. In order to maintain equal exposure, Index Funds need to periodically rebalance, which typically happens once per year in January.

Rebalancing consists of selling over-performing commodities and buying under-performing commodities to bring everything back into a balanced portfolio.




For example: imagine that an index fund has $10m exposed to 5 different commodities. In this case, if #Arabica #coffeefutures double in value, the coffee portion of the portfolio jumps from 20% to ~33% of the portfolio’s value. This means that coffee market moves now will have outsized impacts in the fund’s portfolio.

To bring this portfolio back into balance, the index fund manager will sell some of their coffee position and buy some of the other positions.


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Effects on Commodity Prices

The effect of the rebalance on individual commodities is dependent on 2 factors: the size of the index fund’s positions and the relative performance of the commodity versus the other commodities in the basket.

If index funds have large positions in a commodity, then we could see big price movements as a result of their rebalance. On the other hand, if fund positions are small, then there won't be much impact.

The direction of impact, which can be either bullish or bearish, depends on the relative performance. At the time of rebalance, index funds will sell overperforming commodities (which is bearish) and buy underperforming ones (which is bullish).

To see how this plays out, let’s take a look at the current expectations for the coffee market:

This year Coffee lost 32.2% in one year and the commodity index gained 14.3%. This works out to a 46.6% spread between winners and losers. If we split the difference to get these rebalanced that would mean index funds would buy an additional 23.3% of their position in coffee and sell 23.3% of the other commodities to be back in balance.


From the #CIT report, we know that index funds have currently a total of 36.4k lots in KC. This means they would need to buy 23.3% of 36.4k lots = 8.5k lots.

Using some back of the envelope math, we can see that spec funds have roughly 1 lot to 0.1 basis point impact on coffee prices. If this relationship holds true for index funds, this means that the coffee market could potentially see a ~8.5c rally from the funds’ rebalance.


However, note that this number can vary depending on when and how we do the calculation. Last week, this same math worked out to a 7.3c increase, while it is now at 8.5c. Therefore, the exact timing of the rebalance and of price of KC at that time will be a factor.

Every year around this time (nearing Jan) we hear talks about the “rebalance” and traders try to anticipate the impact on their market, using math like the above. Keep in mind, however, that index funds are aware that they’re being monitored, so they try to avoid front-running by varying timing and strategies to hide their moves.

Conclusion

Since the fund position information is public, and traders are out there trying to anticipate fund rebalance moves, it's quite hard to profit directly from the rebalance.

However, the Rebalance can be a big deal to prices, especially if the index funds have very large positions and there has been a big divergence in particular commodity prices. Even without the rebalance, the rise of index funds is part of the overall increased connectedness between markets and its important for traders to understand the mechanisms for this connectedness.

Connections between markets is part of the overall integration brought about by the digital information age. If we want to trade in this modern era, we need to understand how index funds work ot only for anticipating the rebalance, but also for understanding how capital flows will impact our market. [You made it to the end. Nice work. Now treat yourself to a free trial of our premium Market Intelligence plans and see what all the fuss is about.]


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