Index Investment and the Financialization of Commodities

The authors found that, concurrent with the rapidly growing index investment in commodity markets since the early 2000s, prices of non-energy commodity futures in the United States have become increasingly correlated with oil prices; this trend has been significantly more pronounced for commodities in two popular commodity indices. This finding reflects the financialization of the commodity markets and helps explain the large increase in the price volatility of non-energy commodities around 2008.Since the early 2000s, commodity futures have emerged as a popular asset class for many financial institutions. As a result, investment flows on the order of hundreds of billions of dollars have entered the commodity markets. Various observers and policymakers have expressed a strong concern that index investment as a form of financial speculation might have caused unwarranted increases in the cost of energy and food and induced excessive price volatility.What is the economic impact of the rapid growth of commodity index investment? Prior to the early 2000s, despite the liquid futures contracts traded on many commodities, academic researchers documented several characteristics indicating that commodity markets were partly segmented from outside financial markets and from each other: The commodity prices provided a risk premium for idiosyncratic commodity price risk and had little comovement with stocks and with each other. Recognition of the potential diversification benefits of investing in the segmented commodity markets prompted the rapid growth of commodity index investment after the early 2000s and precipitated a fundamental process of financialization among commodity markets. In our study, we analyzed the effects of this financialization process.Our analysis focused on a salient empirical pattern of greatly increased price comovements between various commodities after 2004, when significant index investment started to flow into commodity markets. Because index investors typically focus on strategic portfolio allocation between the commodity class and other asset classes, such as stocks and bonds, they tend to trade in and out of all commodities in a given index at the same time. As a result, their increasing presence should have a greater impact on commodities in the two most popular commodity indices—the S on the other hand, their portfolio rebalancing can spill price volatility from outside markets on and across commodity markets. Consistent with the volatility spillover effect, our analysis shows that in 2008, indexed non-energy commodities had higher price volatility than did off-index commodities, and this difference was partly related to the greater return correlations of indexed commodities with oil.The changes induced by the index investment flows in commodity price correlation and volatility have profound implications on a wide range of issues, from commodity producers’ hedging strategies and speculators’ investment strategies to many countries’ energy and food policies.