Aepp/ppq 032

Applied Economic Perspectives and Policy (2011) volume 33, number 1, pp. 1– 31.
doi:10.1093/aepp/ppq032
Featured Article
Index Funds, Financialization, and Commodity
Futures Markets
Scott H. Irwin* and Dwight R. Sanders
Scott H. Irwin is the Lawrence J. Norton Chair of Agricultural Marketing,

Department of Agricultural and Consumer Economics, University of Illinois at
Urbana-Champaign; Dwight R. Sanders is a professor in the Department of
Downloaded from http://aepp.oxfordjournals.org/ at Pennsylvania State University on February 27, 2013

Agribusiness Economics, Southern Illinois University Carbondale.
*Correspondence may be sent to: E-mail: sirwin@illinois.edu.
Submitted March 2009; accepted December 2010.
Abstract Some market participants and policy-makers believe that index fund
investment was a major driver of the 2007-2008 spike in commodity futures
prices. One group of empirical studies does find evidence that commodity index
investment had an impact on the level of futures prices. However, the data and
methods used in these studies are subject to criticisms that limit the confidence
one can place in their results. Moreover, another group of studies provides no sys-
tematic evidence of a relationship between positions of index funds and the level
of commodity futures prices. The lack of a direct empirical link between index
fund trading and commodity futures prices casts considerable doubt on the belief
that index funds fueled a price bubble.
Key words: Index funds, commodity, futures markets, prices, specu-
lation, bubble.
JEL Codes: D84, G12, G13, G14, Q13, Q41.
Introduction
The financial industry has developed new products that allow insti-
tutions and individuals to invest in commodities through long-only index
funds, over-the-counter (OTC) swap agreements, exchange traded funds,
and other structured products. Regardless of form, these instruments have
a common goal – to provide investors with buy-side exposure to returns
from a particular index of commodity prices.1
Several influential academic studies concluded that investors can
capture substantial risk premiums and reduce portfolio risk through rela-
tively modest investments in long-only commodity index funds (e.g.,
1
In the remainder of this article, the term “commodity index fund” or “index fund” is used generically
to refer to all of the varied long-only commodity investment instruments. See the discussion in the fol-
lowing section for further details.
# The Author(s) 2011. Published by Oxford University Press, on behalf of Agricultural and Applied
Economics Association. All rights reserved. For permissions, please email:
journals.permissions@oup.com.
1
Applied Economic Perspectives and Policy
Gorton and Rouwenhorst 2006; Erb and Harvey 2006). Combined with the
availability of deep and liquid exchange-traded futures contracts, these
conclusions set off a dramatic surge in commodity index fund invest-
ments. While there is uncertainty about the best way to measure the mag-
nitude of this surge, it is safe to say that at least $100 billion of new
investment moved into commodity futures markets between 2004 and
2008. Domanski and Heath (2007) term this the “financialization” of com-
modity futures markets. Given the size and scope of the index fund boom,
it should probably not come as a surprise that a worldwide debate has
ensued over the role of index funds in commodity markets. This debate
has important ramifications from a policy and regulatory perspective, as
well as practical implications for the efficient pricing of commodity

products.
On one side, a number of hedge fund managers, commodity end-users,
policy-makers, and some economists contend that commodity index
investment was a major driver of the 2007-2008 spike in commodity
futures prices (e.g., Masters 2008; Masters and White 20082; USS/PSI 2009;
De Schutter 2010; Baffes and Haniotis 2010). The massive wave of index
fund buying allegedly created a “bubble” that forced commodity futures
prices well above “fundamental values.” The following statement by Fadel
Gheit, Managing Director and Senior Oil Analyst for Oppenheimer &
Company, Inc., before the Subcommittee on Oversight and Investigations
of the Committee on Energy and Commerce, U.S. House of
Representatives, in June 2008 illustrates this perspective:
“I firmly believe that the current record oil price in excess of $135 per barrel is
inflated. I believe, based on supply and demand fundamentals, crude oil prices
should not be above $60 per barrel . . . There were no unexpected changes in industry
fundamentals in the last 12 months, when crude oil prices were below $65 per barrel.
I cannot think of any reason that explains the run-up in crude oil price, beside exces-
sive speculation,” (Gheit 2008, p.2).
This line of reasoning fueled political pressure to limit speculative pos-

itions in commodity futures markets, particularly in energy futures
markets. The recently-passed 2010 Dodd-Frank Wall Street Reform and
Consumer Protection Act provided regulators with the authority needed to
implement such limits. The Commodity Futures Trading Commission
(CFTC) now has broad authority to set aggregate speculative position
limits on futures and swap positions in all non-exempt “physical com-
modity markets” in the United States.
On the other side, a number of market analysts and economists have
expressed skepticism about the bubble argument, citing logical inconsis-
tencies and contrary facts (e.g., Krugman 2008; Pirrong 2008; Sanders and
Irwin 2008; Smith 2009). This group has argued that commodity markets
in 2007-2008 were driven by fundamental supply and demand factors that
pushed prices higher not “excessive speculation.” Factors cited as driving
the price of crude oil include strong demand from China, India, and other
developing nations, a leveling out of crude oil production, a decrease in
the responsiveness of consumers to price increases, and U.S. monetary
policy (e.g., Hamilton 2009a; Kilian and Murphy 2010). In the grain
markets, the diversion of row crops to bio-fuel production and weather-
2
Masters, Michael W., and Adam K. White. 2008. The Accidental Hunt Brothers: How Institutional
Investors are Driving up Food and Energy Prices. http://accidentalhuntbrothers.com/.
2
Index Funds and Futures
related production shortfalls are cited, as well as demand growth from

developing nations, U.S. monetary policy, and a lack of investment in
basic production infrastructure (e.g., Trostle 2008; Wright 2009).
Even though over two years have passed since the 2008 peak in commodity
prices, the controversy surrounding index funds continues unabated. For
instance, Michael Masters, Portfolio Manager for Masters Capital Management,
LLC, made the following statement at a March 2010 CFTC hearing:
“Passive speculators are an invasive species that will continue to damage the markets
until they are eradicated. The CFTC must address the issue of passive speculation; it
will not go away on its own. When passive speculators are eliminated from the markets,
then most consumable commodities derivatives markets will no longer be excessively
speculative, and their intended functions will be restored,” (Masters 2010, p.5).

Joachim von Braun, director of Germany’s Center for Development
Research, made these comments at a March 2010 conference linking high
food prices and world hunger:
“We have good analysis that speculation played a role in 2007 and 2008 . . .
Speculation did matter and it did amplify, that debate can be put to rest. These
spikes are not a nuisance, they kill. They’ve killed thousands of people,”3.
These statements illustrate the acrimonious and heated nature of the

public policy debate surrounding the role of index funds in commodity
futures markets.
The purpose of this article is to provide a thorough review and synthesis
of the arguments on both sides of the debate about the impact of index funds
in commodity futures markets, as well as a careful assessment of the latest
empirical research on the subject. We consider empirical studies that test for
general bubble-like price activity over the 2007-2008 period, as well as those
that specifically link market behavior to index fund positions. This “taking
stock” is important given the stakes involved in the outcome of the debate. If
index fund investment was responsible for a large bubble in commodity
futures prices, difficult questions are raised about the basic price discovery
and risk-shifting functions of these markets. New regulatory limits on specu-
lation would likely be justified even if costly to some market participants. If
supply and demand fundamentals rather than index investment were
responsible for the commodity price spike, then new limits on speculation
would not be justified and could do substantial harm to the efficient func-
tioning of these markets. Before delving into the arguments and evidence,
we provide an overview of commodity index funds in the next section.
Commodity Index Funds

Commodity index investments share the common goal of tracking the
broad movement of commodity prices. The Standard and Poor’s-Goldman
Sachs Commodity IndexTM (S&P-GSCI), is one of the most widely tracked
indices and is generally considered an industry benchmark; it is computed
as a (quantity) production-weighted average of the prices from 24 com-
modity futures markets. While the index is well-diversified in terms of
number of markets and sectors, the production-weighting results in a
3
As quoted in: Ruitenberg, Rudy. 2010. Global Food Reserve Needed to Stabilize Prices, Researchers
Say. Bloomberg.com. March 29. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=au9X.
0u6VpF0.
3
relatively large 67% weight towards the energy sector, and a fairly small
21% in traditional livestock and agricultural markets.4 The other industry
benchmark is the Dow Jones-UBS Commodity IndexTM (DJ-UBS). The
DJ-UBS market weights are based on a combination of economic signifi-
cance and market liquidity, with a maximum weight of 33% in any sector.
Energy markets receive a weight of 28%, and the livestock and agricultural
sectors combine to 40% of the DJ-UBS index.5 In both of these popular
indices, the market weights, contract switching or rollover conventions,
and contract months traded are well-publicized, resulting in a transparent
and well-defined index.
Investors can gain exposure to commodity indices through a number of
investment vehicles, but the positions often find their way to the commodity

futures markets.6 A minority of institutions and individuals may gain com-
modity exposure by directly purchasing futures contracts in a manner that
mimics a popular index. However, this number is relatively small, as most
institutions are barred from directly trading futures (Stoll and Whaley 2010),
and most individuals would have difficulty replicating a broad-based index.
As an alternative to directly purchasing futures, institutions often invest in a
fund that promises to mimic a popular commodity index. The fund manager
will then either directly invest in futures or gain the promised market
exposure by entering an over-the-counter (OTC) swap contract with a swap
dealer. Swaps and other OTC derivatives are popular because they can be tai-
lored by a swap dealer to meet the specific needs of a client. An index swap is
a derivative contract structured to provide a payoff that is indexed to one of
the popular commodity indices (see Chapter 5, Hull (2000), for examples of
swap contracts). The swap dealer will in turn enter the futures market and
take long positions in the corresponding futures contracts to offset the risk
associated with their side of the OTC derivative. As an alternative, insti-
tutional investors may choose to bypass the fund and enter directly into a
commodity return swap with a swap dealer. Again, the swap dealer will be
the agent who actually takes the long positions in the futures markets.
For individual investors, investment firms offer funds whose returns are
tied to a commodity index. Both exchange-traded funds (ETFs) and struc-
tured notes (ETNs) have been developed that track commodity indices.
ETFs are essentially mutual fund shares that trade on a stock exchange
and are designed such that the share price tracks a designated commodity
index. ETN’s are actually debt securities where the issuer promises to
make pay-outs based on the value of the underlying commodity index.
Both ETFs and ETNs trade on exchanges in the same manner as stocks on
individual companies. The management company that initially offers and
manages the fund or note collects a fee for their services. To gain com-
modity exposure, ETF and ETN managers can either buy futures contracts
directly, or more likely, utilize OTC commodity return swaps. The swap
dealer will subsequently purchase commodity futures contracts to hedge
their commodity exposure related to the swap transactions.
4
As of October 15, 2010. (http://www2.goldmansachs.com/services/securities/products/sp-gsci-commodity-
index/index.html).
5
As of September 30, 2010. (http://www.djindices.com/mdsidx/downloads/fact_info/Dow_Jones-UBS_
Commodity_Index_Fact_Sheet.pdf ).
6
See Engelke and Yuen (2008) and Stoll and Whaley (2010) for further details on the various commod-
ity index investment instruments.
4
Figure 1 Flow of index investments into commodity futures markets

Sanders, Irwin, and Merrin (2010) show that roughly 85% of index-
related positions in agricultural futures markets are held by swap dealers.
In the non-agricultural markets this percentage is likely to be even higher.
However, swap dealers run a much larger “book” of OTC transactions than
just index investments. A swap dealer may have a customer who is a tra-
ditional short hedger, whose position offsets the long position desired by
an ETF. In this case, the swap dealer “nets” the two positions internally
and may not have to go to the futures market to place a long hedge if the
positions offset one another. If long hedging in futures is required, it may
be in a much smaller quantity than the original index swap made with the
ETF due to internal netting. Swap dealer netting has been shown to be rela-
tively small in agricultural futures markets, where swap dealers do rela-
tively little non-index business; however, it can be quite large in the energy
and metals markets (CFTC 2008). Figure 1 demonstrates the alternative
flow of total commodity index investments into net futures positions.
Measuring the size of commodity index investment is no simple matter. In
addition to the netting issue discussed above, there are issues related to count-
ing U.S. versus non-U.S. investments, and how to determine what qualifies as
an “index” product. The CFTC has developed three different series related to
commodity index investment in U.S. futures markets; this reflects the various
assumptions about measuring index investment (see Irwin and Sanders (2010)
for a discussion of the three series). Figure 2 presents combined U.S. and
non-U.S. asset totals in commodity index products collected by Barclays
Capital – one of the longest and oldest series available – from the fourth
quarter of 2004 through the third quarter of 2010. This series indicates that
assets surged by over $200 billion starting in late 2004, reaching a peak of over
$250 billion in mid-2008. Following a sharp decline during the recession, assets
resumed their upward climb, reaching a new peak of about $300 billion at the
end of the third quarter of 2010.7 The plot also reveals that nearly all of the
7
Index investment data collected by the CFTC provides smaller estimates of the assets in index funds.
At the end of the second quarter of 2008, CFTC data indicated the total was $201 billion compared to
$269 billion for the Barclays Capital data. The gap between the two series expanded to $132 billion at
the end of the second quarter of 2010.
5
Figure 2 U.S. and non-U.S. assets in commodity index products, first quarter, 2004-third
quarter, 2010

recent growth in assets has been in exchange-traded products and commodity
notes. Finally, it is important to remember when viewing such data that it
measures total assets under management, which is affected by inflows and out-
flows of investment funds and commodity price changes.
Further perspective on the size of commodity index investment is pro-
vided in Figures 3 –6; these figures show the net long (long minus short
contracts), open interest of commodity index funds, and the percentage of
total long open interest (futures only) represented by these positions in
four grain futures markets: Chicago Board of Trade (CBOT) corn, soy-
beans, and wheat, and Kansas City Board of Trade (KCBOT) wheat. The
data are observed at weekly intervals from January 7, 2004 to September
7, 2010, and are reported in the CFTC’s Supplemental Commitments of
Traders report (widely referred to as the commodity index trader report
Figure 3 Weekly net long open interest of commodity index traders (CIT) and CIT percentage
of market (long) open interest for Chicago Board of Trade (CBOT) corn futures market,
January 6, 2004 - September 7, 2010
6
of market (long) open interest for Chicago Board of Trade (CBOT) soybean futures market,

of market (long) open interest for Chicago Board of Trade (CBOT) wheat futures market,
(CIT).8 Trends in the net long positions of CITs in these four markets
roughly parallel the overall trends in commodity index investment shown
in Figure 2. There are some differences across markets, however. CIT net
long open interest in CBOT corn and wheat first peaked in early 2006, and
did not exceed this peak until very recently. CBOT soybeans and KCBOT
wheat did not reach their first peak until later, in mid- to late-2007. CIT
percentage of total market open interest probably best illustrates the sheer
size of index fund positions, which has ranged recently from approxi-
mately 20-30% of the long side of the market in CBOT corn and soybeans
8
Position data for 2004-2005 were prepared by the CFTC at the request of the U.S. Senate Permanent
Subcommittee on Investigations (USS/PSI 2009). We thank the staff of the subcommittee for allowing
us to use this data.
7
of market (long) open interest for Kansas City Board of Trade (KCBOT) wheat futures
market, January 6, 2004 - September 7, 2010

and KCBOT wheat, and 30-40% in CBOT wheat. By any reasonable stan-
dard, index investment positions, at least in these grain futures markets,
are indeed very large.
A relevant question in light of the large positions of commodity index
funds is whether the positions should be considered speculation, hedging,
or something altogether new. Stoll and Whaley (2010) argue that commod-
ity index investments are not speculative because the investments are
long-only, passive, fully-collateralized, and motivated by portfolio diversi-
fication benefits. This is an accurate description of the way commodity
index investments are developed and marketed to investors. Most public
statements by institutional investors emphasize the primary advantage of
commodity investments as diversification – providing a return that is
uncorrelated with core equity and bond holdings. However, what is not
known with any degree of certainty is the actual motivation of insti-
tutional or individual investors in commodity index funds. While the
funds are strictly long-only, they can still be used by investors as a trading
instrument; money can be invested in index funds when expected returns
are believed to be high and withdrawn when returns are expected to be
low or negative. Intriguing evidence on the motivation of commodity
investors is provided by a recent Barclays Capital survey (Norrish 2010).
In response to the question, “Why do you invest in commodities,” 43% of
respondents said portfolio diversification, 31% said absolute returns, 9%
said inflation hedge, and 17% said emerging market growth. The
responses indicate that there is a speculative component to at least some
commodity index fund positions.
What is a Bubble?
Brunnermeier (2008, p.578) defines a bubble as, “ . . . asset prices that
exceed an asset’s fundamental value because current owners believe that
they can resell the asset at an even higher price in the future.” While this
definition is slightly different from some of the more classical references
8
(O’Hara 2008), it is largely consistent with popular notions. That is, a

bubble is characterized by two elements. First, prices are “inexplicable
based on fundamentals” (Garber 2000, p. 4). Second, the trading motive
itself is unrelated to fundamental values, as market participants believe
they can always sell to a greater fool. The end result is the classic market
action identified (ex post) as, “ . . . an upward price movement over an
extended range that then implodes,” (Kindleberger 1996, p. 13). The econ-
omic damage from an asset pricing bubble may be extensive since the
market provides false signals about value. In particular, an inflated price
may induce the over-production of an asset and misallocation of pro-
ductive resources.
To understand the conditions for an asset pricing bubble to occur, it is

useful to first review the assumptions that ensure rational asset pricing—
usually defined as a situation where market price equals the present
value of the future income stream associated with an asset (fundamental
value). Theoretical modeling (e.g., Tirole 1982) has deduced several key
assumptions necessary for rational asset pricing: i) an infinite number of
potential traders; ii) traders believe other traders are rational; iii) traders
start with the same prior beliefs about the future income stream; iv) no
restrictions on short-selling or arbitrage; and v) the economy has an effi-
cient allocation of resources before trading begins. If any of these assump-
tions are violated, then a pricing bubble can form. For example, bubbles
can occur with the large-scale entry of unsophisticated “noise” traders
who have mistaken beliefs about their prospects for future income
streams. Rational traders would normally arbitrage any mispricing that
results, but they may also restrain arbitrage positions due to noise trader
risk (De Long et al. 1990). Noise trader risk stems from the unpredictabil-
ity of noise trader positions. However, if noise traders behave in a pre-
dictable fashion, there is no noise trader risk, and asset pricing bubbles
cannot occur.9
From the perspective of economic theory, commodity futures contracts
are not the type of market one would predict as being likely susceptible to
bubble-like activity. Specifically, futures contracts are finite-horizon instru-
ments with virtually no constraints on short-sales, which eliminate the
potential for a bubble in theoretical models (if the other assumptions
listed above hold). In addition, long-lasting bubbles are less likely in
markets where deviations from fundamental value can be readily arbi-
traged away (easily “poached” in the terminology of Patel, Zeckhauser,
and Hendricks (1991)). There are few limitations to arbitrage in commod-
ity futures markets, because the cost of trading is relatively low, trades can
be executed literally by the second, and prices are highly transparent. This
stands in contrast to markets where arbitrage is more difficult, such as
residential housing. The low likelihood of bubbles is also supported by
many studies on the efficiency of price discovery in commodity futures
markets (see Zulauf and Irwin 1998; Carter 1999; Garcia and Leuthold
2004). Finally, experimental evidence – which largely supports the exist-
ence of bubbles – shows that the introduction of a futures market lessens
the incidence of bubbles (Forsythe, Palfrey, and Plott 1984; Noussair and
Tucker 2006).
9
See Barlevy (2007) for a readable and non-technical discussion of the conditions in which asset
pricing bubbles can occur.
9
While it is arguable that bubbles have actually occurred with any fre-
quency in financial history, at least in the sense defined by economists, the
term has definitely been more in vogue over the last decade, with pro-
claimed “bubbles” in information technology stocks and residential
housing, as well as suspected bubbles in U.S. Treasury securities and com-
modity futures prices. Indeed, while economists are typically careful in
their use of the term “bubble,” the popular press has seemingly adopted
the label for any market that makes a large advance quickly and then
makes an equally hasty retreat. As Barlevy (2007) points out, the problem
with this popular usage is that large price swings sometimes occur natu-
rally and in response to shifts in supply and demand. This highlights the
main difficulty of identifying an asset pricing bubble: disentangling move-

ments in an asset’s price due to changing supply and demand fundamen-
tals from those due to bubble behavior. This is especially hard because
fundamental value depends not only on expectations about futures
income streams, but also upon discount (interest) rates.
It Was a Bubble
The Arguments
Masters (2008) has interwoven investment and price data to create the
most widely-cited bubble argument, painting the activity of index funds
as being akin to the infamous Hunt brothers’ cornering of the silver
market in the early 1980s. Masters blames the rapid increase in overall
commodity prices from 2007-2008 on institutional investors’ embrace of
commodities as an investable asset class. As discussed in the previous
section, it is clear that considerable investment dollars flowed into com-
modity index funds over this time period. However, the evidence pro-
vided by Masters is limited to anecdotes and the temporal correlation
between money flows and prices. Masters and White (2008) recommend
specific regulatory steps to address the alleged problems created by index
fund investment in commodity futures markets, including the
re-establishment of speculative position limits for all speculators in all
commodity futures markets, as well as the elimination or severe restriction
of index speculation.
A similar position was taken by the U.S. Senate Permanent
Subcommittee on Investigations in its examination of the performance of
the CBOT wheat futures contract:
“This Report finds that there is significant and persuasive evidence to conclude that
these commodity index traders, in the aggregate, were one of the major causes of
“unwarranted changes” – here, increases – in the price of wheat futures contracts
relative to the price of wheat in the cash market. The resulting unusual, persistent
and large disparities between wheat futures and cash prices impaired the ability of
participants in the grain market to use the futures market to price their crops and
hedge their price risks over time, and therefore constituted an undue burden on
interstate commerce. Accordingly, the Report finds that the activities of commodity
index traders, in the aggregate, constituted “excessive speculation” in the wheat
market under the Commodity Exchange Act,” (USS/PSI 2009, p. 2).
Based on these findings, the Subcommittee recommended the: 1) phase

out of existing position limit waivers for index traders in wheat; 2) if
necessary, the imposition of additional restrictions on index traders, such
10
as a position limit of 5,000 contracts per trader; 3) investigation of index

trading in other agricultural markets; and 4) the strengthening of data col-
lection on index trading in non-agricultural markets.
One of the limitations of the bubble argument made by Masters is that
the link between money inflows from index funds and commodity futures
prices is not well developed. This allows critics to assert that bubble pro-
ponents make the classical statistical mistake of confusing correlation with
causation. In other words, simply observing that large investment has
flowed into the long side of commodity futures markets at the same time
that prices have risen substantially does not necessarily prove anything
without a logical and causal link between the two. One attempt to estab-
lish this linkage was delivered in testimony by Todd Petzel, Chief

Investment Officer for Offit Capital Advisors, at a July 2009 CFTC hearing
on position limits in energy futures markets:
“Seasoned observers of commodity markets know that as non-commercial partici-
pants enter a market, the opposite side is usually taken by a short-term liquidity pro-
vider, but the ultimate counterparty is likely to be a commercial. In the case of
commodity index buyers, evidence suggests that the sellers are not typically other
investors or leveraged speculators. Instead, they are owners of the physical commod-
ity who are willing to sell into the futures market and either deliver at expiration or
roll their hedge forward if the spread allows them to profit from continued storage.
This activity is effectively creating “synthetic” long positions in the commodity for
the index investor, matched against real inventories held by the shorts. We have seen
high spot prices along with large inventories and strong positive carry relationships
as a result of the expanded index activity over the last few years,” (Petzel 2009,
pp. 8-9).
In essence, Petzel (2009) argues that unleveraged futures positions of

index funds are effectively synthetic long positions in physical commod-
ities, and hence represent new demand. If the magnitude of index fund
demand is large enough relative to physically-constrained supplies in the
short-run, prices and price volatility can increase sharply. The bottom line
is that the size of index fund investment is “too big” for the size of com-
modity futures markets.
Hamilton (2009b) develops a formal model of price determination in the
crude oil market that generates specific theoretical conditions for speculat-
ive impact; he begins by noting that the key challenge is reconciling a
speculative bubble in crude oil prices with changes in the physical quan-
tities of crude oil. A standard argument is that a price bubble will inevita-
bly lead to a rise in inventories as the quantity supplied at the “bubble
price” exceeds the quantity demanded (Krugman 2008). Hamilton’s theor-
etical model is based on a profit-maximizing representative refiner of
crude oil into gasoline, an exogenous supply of crude oil, and a demand
function for gasoline. Solution of the model for the optimal inventory
management condition of the refiner leads to important predictions about
price behavior and inventories. In particular, if the demand for gasoline is
perfectly inelastic and speculators are able to force up the forward
(futures) price of crude oil for non-fundamental reasons, this will force
the current (spot) price of crude oil to rise in order to maintain equili-
brium in the storage market. However, if the elasticity of gasoline demand
is less than perfectly inelastic, the standard result follows that inventories
must also increase.
Caballero, Farhi, and Gourinchas (2008) develop a theoretical model
that emphasizes the underlying “macro” forces that may be driving a
11
bubble in commodity prices. The model divides the world into two
regions; the first has developed financial markets, and the other does not.
Since commodity producers are assumed to be located in the region with
less developed financial markets, producers are forced to hold financial
assets from the developed region as a store of wealth, which leads to a
decline in real interest rates in this region. Bubbles form in asset markets,
including commodity markets, in response to the decline in real interest
rates. Once again, a key prediction of this model is that commodity inven-
tories accumulate during the building phase of the price bubble. An inter-
esting feature of this model is that equilibrium is invariant to the presence
of a futures market. The bubble is ultimately fed only by global imbal-
ances in the supply of liquid and safe financial assets.

Empirical Evidence
We review here five studies that provide empirical evidence of a bubble
and/or a statistical linkage between index fund activity and commodity
futures price movements. These studies are selected because they contain
statistical analysis that directly tests whether the recent commodity price
spike contained a bubble component and/or whether index fund trading
contributed to the price spike.10
Gilbert (2009) examines price behavior in crude oil futures, three metals
futures, and three agricultural futures over 2006-2008. He first tests
directly for bubbles using a new time-series test developed by Phillips,
Wu, and Yu (2009). Tests using daily data indicate bubbles in seven of the
nine markets, but for a surprisingly small percentage of the days in the
sample. For instance, statistically significant bubbles are present in only 21
out of the 753 days for crude oil futures, or less than 3% of the entire
2006-2008 sample period. Not surprisingly, the “bubble days” are concen-
trated entirely near the peak of prices in the summer of 2008. Gilbert also
constructs a quantum index of commodity index fund investment in
futures markets using positions of index traders in the 12 agricultural
markets reported in the CFTC’s weekly CIT report. Granger causality tests
are used to establish whether lagged changes in the quantum index help
to forecast returns ( price changes) in each of the seven markets included
in the analysis. The results indicate a significant relationship between
index fund trading activity and returns in three of the seven markets:
crude oil, aluminum, and copper. Gilbert estimates the maximum impact
of index funds in these markets to be a price increase of 15%.
Gilbert’s (2009) results point towards a non-negligible impact of index
funds on price in at least some commodity futures markets. There are
reasons for caution, however. The first is that rejection of the null hypoth-
esis in a Granger causality test should be viewed as only a preliminary
indication of a true casual relationship. Newbold (1982) provides a classic
discussion of the problems that can arise in rejecting the null in such tests,
and these include: i) economic agents’ expectations about the future can
make it appear as if there is a relationship between two variables when in
fact there is none; ii) the apparent causal relationship between two vari-
ables may actually be the result of a third variable omitted from the
10
We make no claim to having uncovered any and all studies that may contain such evidence. This is
certainly an active area of current economic research around the world and additional studies will
undoubtedly emerge.
12
analysis; and iii) without an explicit theory that establishes a link between
two variables, the meaning of a non-zero correlation is unclear.
The second reason is related to the index of commodity index fund
activity used by Gilbert (2009); his quantum index is a weighted average
of index trader positions in agricultural futures markets (as reported in
the CFTC’s CIT report). The weights are nearest-to-expiration futures
prices on the first date of his sample. Gilbert (2009) then applies this index
not only to three of the agricultural markets included in the index, but
also to the energy and metal markets not included in the index.
Application of an index constructed from the 12 CIT agricultural markets
to the energy and metals markets is justified only if one believes the
pattern of index trader positions in agricultural markets closely mirrors

the pattern in energy and metals markets. Gilbert (2009) presents no evi-
dence whether this is a reasonable assumption or not. This point is
reinforced by noting that he did not find evidence of a relationship
between index fund activity in agricultural markets, upon which the index
is based, but did find evidence in energy and metals markets, which are
not included in the index.
Gilbert (2010) investigates the factors driving the 2007-2008 increase in
food prices; he argues that agricultural price booms are better explained
by common demand-side factors than individual market supply-side
factors. He goes on to specify a multi-equation model where changes in
aggregate food commodity prices are a function of changes in the price of
crude oil, commodity index investment, and a U.S. dollar exchange rate
index. Changes in the price of oil and commodity index investment are
endogenous variables, and the change in the U.S. dollar exchange rate is
exogenous. Commodity index investment is measured using the same
quantum index as in his 2009 study, and it is specified as a function of
changes in the U.S. dollar index, Chinese industrial production, and U.S.
and Chinese stock market indices. This specification is based on the argu-
ment that index investment is not driven by portfolio diversification, but
rather by investors’ view that the demand for raw material from China
will push up commodity prices.
Gilbert (2010) estimates model parameters using monthly data from
March 2006 to June 2009, which indicate a large and statistically significant
impact of commodity index investment on the food price index. However,
Gilbert does not interpret index investment as a fundamental cause of the
food price boom, but instead it is viewed as the channel by which the
main drivers – rapid Chinese economic growth and dollar depreciation –
affected the price of food. This is another form of the argument that
underlying “macro” forces created a bubble in commodity prices rather
than index funds per se (Caballero, Farhi, and Gourinchas 2008). Once
again, there are good reasons for caution when interpreting these results.
For example, the sample period is very short for estimating a structural-
type econometric model (which the author acknowledges). Further, the
model implicitly assumes that index investment is entirely speculative,
certainly a controversial assumption. Finally, there is little information
about the sensitivity of estimation results to alternative specifications of
the variables included in the model. It would not be surprising to find
that results are quite sensitive to model specification given the short time
period used to estimate the model.
13
Einloth (2009) devises a test of bubbles based on the joint behavior of

convenience yields and prices in a storable commodity futures market.
Here, convenience yield is the flow of benefits that accrue to inventory
holders from having stocks of the commodity on hand. For example, the
costs of shutting down an oil refinery due to the unavailability of crude
oil may be very high; thus, the operator may hold some stocks as insur-
ance against this possibility. The basic theory of storage predicts that low
inventories lead to a rising commodity price and an increasing marginal
convenience yield (Working 1948; 1949). Thus, the combination of a rising
futures price and a falling marginal convenience yield is a violation of this
theory. Einloth uses this condition as a test for speculative impact in the
crude oil futures market, and finds that marginal convenience yield

(derived from differences between futures prices) rose for most of the
increase in crude oil futures prices up to $100/barrel, but fell as crude oil
increased from about $100 to $140/barrel. While this indicates that specu-
lation may have played a role near the peak in crude oil prices, the tech-
nique cannot attribute this to a particular group of market participants,
such as index funds.
There is no doubt that Einloth is correct in arguing that the basic theory
of storable commodity markets rules out the combination of falling mar-
ginal convenience yield and rising futures prices. However, more sophisti-
cated versions of the theory show that this combination can occur, not due
to speculative impacts, but because market participants are reacting ration-
ally to a particular set of incentives. For example, Routledge, Seppi, and
Spatt (2000) develop an equilibrium model of price behavior for a storable
commodity where the spot commodity has an embedded timing option
that is a function of endogenous inventory and exogenous supply and
demand shocks. In this model, falling marginal convenience yield can be
observed at the same time that futures prices are rising if the value of the
timing option is large enough. This could occur if the probability of a
sequence of large positive demand shocks or negative supply shocks
increases substantially. The implication is that Einloth’s test may not ident-
ify bubbles, but instead unusual periods where the timing option derived
from holding inventories increases at the same time that price also rises.
Tang and Xiong (2010) do not test for bubbles in commodity futures
prices. Instead, they argue that commodity markets were not fully inte-
grated with financial markets prior to the development of commodity
index investments and, “The increasing presence of index investors in
commodities markets precipitated a fundamental process of financializa-
tion amongst the commodities markets, through which commodity prices
now become more correlated with the prices of financial assets and each
other,” ( p. 2). Statistical tests confirm that the correlation of commodity
futures returns with stock, bond, U.S. dollar, and crude oil returns
increased significantly starting in 2004. Some of the increases are remark-
able. For example, the correlation of daily soybean and crude oil futures
returns before 2004 moved in a narrow range between .10 and 0.20, but
after 2004 increased steadily to a peak of about 0.60 in 2009.
Tang and Xiong recognize that increasing correlations could be due to a
variety of factors, such as the financial shocks associated with the recent
recession and the increasing impact of crude oil prices on many commod-
ities (e.g., de Gorter and Just 2010), and address this “identification” issue
with a difference-in-difference approach. Specifically, they test whether the
14
increase in correlation of commodity futures returns with stock, bond, U.S.

dollar, and crude oil returns post-2004 is greater for commodities included
in major indices (such as the-S&P-GSCI) compared to commodities not
included in the indices. A statistically significant increase for in- versus
off-index commodity markets is estimated for five non-energy sectors,
leading the authors to conclude that index investment has increasingly
impacted commodity futures prices (although in a non-bubble manner).
Tang and Xiong’s study appears to provide concrete evidence of a
linkage between commodity index investment and futures price move-
ments. The results are also consistent with other types of evidence about
the price impact of investment flows in financial markets (Barberis,
Shleifer, and Wurgler 2005). Nonetheless, there are several reasons for

viewing Tang and Xiong’s findings with caution. The first reason is that
the average magnitude of correlation increases is small after 2004 for in-
versus off-index commodities. The simplest way to emphasize this point
is to compare the estimated correlations across in- and off-index commod-
ities for the final year of the sample, 2009. Considering the results for
regressions in which correlations (exposures) are estimated jointly for all
four financial variables (regression (6) in their table 5), one discovers that
differences in correlations for in- versus off-index commodities in 2009
average only 0.05, -0.03, -0.06, and 0.14 for equity index, bond index,
dollar index, and crude oil returns, respectively, across the five commodity
sectors. While these differences generally are statistically significant, the
economic significance of such small differences is debatable.
The second reason for viewing Tang and Xiong’s findings with caution
is that the difference-in-difference approach used by the authors may not
adequately control for fundamental factors that are common to all com-
modities in a given sector. Ai, Chatrath, and Song (2006) show how a
failure to properly condition on market fundamentals can lead to incorrect
inferences in co-movement tests. A particular concern with Tang and
Xiong’s study is the representativeness of the non-index “control” markets
in some sectors. Two of the four non-index markets in the grain sector are
rough rice and oats futures, both of which are thinly-traded and illiquid
markets. The same can be said of the only two non-index markets in the
soft commodity sector, lumber and orange juice. The most egregious
example is in the livestock sector, where the sole non-index market is pork
bellies. This is, for all intents and purposes, a dead market with close to
zero open interest. Comparison to illiquid and unrepresentative markets
could induce a bias in the difference-in-difference regression estimates.
The third reason for viewing Tang and Xiong’s findings cautiously is that
several other studies indicate that commodity futures markets have been
integrated with financial markets for decades, contradicting Tang and
Xiong’s basic thesis. For example, Bjornson and Carter (1997) examine seven
commodity futures markets from 1969-1994, and find that expected returns
are lower during times of high interest rates, expected inflation, and econ-
omic growth, leading the authors to conclude that commodities provide a
natural hedge against business cycles. In a recent paper, Hong and Yogo
(2010) document that information about future inflation has been priced into
commodity futures markets since at least the mid-1960s (albeit with a delay).
Phillips and Yu (2010) introduce a new recursive test for bubble charac-
teristics in financial time series. Essentially, the sequential procedure uses
standard tests (Dickey-Fuller t tests) for unit root behavior in prices
15
against “mildly explosive alternatives” that would characterize a bubble.

The recursive procedure is powerful in the sense that it allows for the
“time stamping” of the start and end date for a bubble, and it can be
applied in real time to identify when a bubble is forming. Following
Caballero, Farhi, and Gourinchas (2008), the authors hypothesize that
global liquidity imbalances drove a series of financial bubbles that
migrated from technology stocks to housing, on to subprime mortgages,
and then into commodity markets and eventually the bond market (after
the subprime crises broke). Test results are largely consistent with this
sequence, identifying a bubble in subprime mortgage derivatives from
August 2005 through July 2007, which then migrated to selected commod-
ity markets. Specifically, the authors find evidence of bubble price charac-

teristics from March 2008 to August 2008 in crude oil and heating oil.
Notably, however, there is no evidence of a bubble in prices for coffee,
cotton, cocoa, sugar or feeder cattle.
The findings of Phillips and Yu (2010) are certainly interesting and rep-
resent some of the more convincing evidence of bubble-like activity in
energy prices. However, the lack of evidence for the other commodities
tested is inconsistent with the notion that a wave of index fund buying
pushed up all commodity prices. Moreover, the authors’ selection of
markets (e.g., feeder cattle) and data (e.g., deflated spot prices) may not
translate to equivalent findings in the grain and oilseed futures markets,
where concerns about a bubble are typically focused.
To summarize, the studies reviewed in this section are interesting, rigor-
ous, and make a valuable contribution to the debate about the market
impact of commodity index funds. Results in these studies also negate the
argument that no evidence exists of a bubble in commodity futures prices
or a relationship between commodity index investment and movements in
commodity futures prices. However, the data and methods used in these
studies are subject to a number of important criticisms that limit the
degree of confidence one can place in the results.
It Was Not a Bubble

The Arguments
A number of economists have expressed skepticism about the bubble
argument (e.g., Krugman 2008; Pirrong 2008; Sanders and Irwin 2008;
Smith 2009). These economists cite several contrary facts and argue that
commodity markets were driven by fundamental factors that pushed
prices higher. Irwin, Sanders, and Merrin (2009) and Pirrong (2010)
present useful summaries of the counter-arguments made by economists.
We categorize these into three logical inconsistencies in the arguments
made by bubble proponents and four instances where the bubble story is
not consistent with observed facts.
The first possible logical inconsistency within the bubble argument is
equating demand with money inflows to commodity futures markets.
With equally informed market participants, there is no limit to the
number of futures contracts that can be created at a given price level.
Index fund buying in this situation is no more “new demand” than the
corresponding selling is “new supply.” Futures contracts are “pure bets”
in this context (Black 1976), with a long for every short such that
16
commodity futures markets are zero-sum games. This implies that money
flows in and of themselves do not necessarily impact prices. Rather, prices
will only change if new information emerges that causes market partici-
pants to revise their estimates of physical supply and/or demand.
What happens when market participants are not equally informed?
When this is the case, it is rational for participants to condition demands
on both their own information and information about other participants’
demands that can be inferred (“inverted”) from the futures price
(Grossman 1986). The trades of uninformed participants can impact prices
in this more realistic model if informed traders mistakenly believe that
trades made by uninformed participants (“noise”) reflect valuable infor-
mation about supply and demand fundamentals. Hence, it is possible that

other traders in commodity futures markets interpreted the large order
flow of index funds on the long side of the market as a reflection of valu-
able private information about commodity price prospects, which would
have had the effect of driving prices higher as these traders revised their
own demands upward. Of course, this would have required a large
number of sophisticated and experienced traders in commodity futures
markets to reach the conclusion that index fund investors possessed valu-
able information that they themselves did not possess.
The second possible logical inconsistency of the bubble story is in the
argument that index fund investors artificially raised both futures and
cash commodity prices when they only participated in futures markets.
These contracts are financial transactions that only rarely involve the
actual delivery of physical commodities. In order to impact the equili-
brium price of commodities in the cash market, index investors would
have to take delivery and/or buy quantities in the cash market and hold
these inventories off the market. Index investors are purely involved in a
financial transaction using futures markets; they do not engage in the pur-
chase or hoarding of the cash commodity and any causal linkages
between their futures market activity and cash prices is unclear at best.
A third possible logical inconsistency of the bubble argument is the
blanket categorization of speculators, particularly index fund speculators,
as wrongdoers, and hedgers as victims of their actions. In reality, the “bad
guy” is not so easily identified since hedgers sometimes speculate and
some speculators also hedge. For example, large commercial firms may
have valuable information gleaned from their far-flung cash market oper-
ations and then trade based on that information.11 The following passage
from a recent article on Cargill, Inc. nicely illustrates the point:
“Wearing multiple hats gives Cargill an unusually detailed view of the industries it
bets on, as well as the ability to trade on its knowledge in ways few others can
match. Cargill freely acknowledges it strives to profit from that information. “When
we do a good job of assimilating all those seemingly unrelated facts,” says Greg
Page, Cargill’s chief executive, in a rare interview, “it provides us an opportunity to
11
Hieronymus (1977) argued that large commercial firms dominated commodity futures markets, and
speculators tended to be at a disadvantage. Based on his theoretical analysis, Grossman (1986,
p. S140) asserted, “ . . . it should come as no surprise if a study of trading profit finds that traders
representing large firms involved in the spot commodity (i.e., commercial traders) make large trading
profits on futures markets.” In the classic empirical study on this subject, Hartzmark (1987) showed
that large commercial firms in six of seven futures markets make substantial profits on their futures
trades.
17
make money . . . without necessarily having to make directional trades, i.e., outguess
the weather, outguess individual governments,” (Davis 2009).
The implication is that the interplay between varied market participants is

more complex than a standard textbook description of pure risk-avoiding
hedgers and pure risk-seeking speculators. The reality is that market
dynamics are ever – changing, and it can be difficult to understand the
motivations and market implications of trading, especially in real-time.
In addition to the logical inconsistencies, there are several ways the
bubble story is not consistent with the observed facts. First, theoretical
models (Caballero, Farhi, and Gourinchas 2008; Hamilton 2009b) show
that if a bubble raises the market price of a storable commodity above the

true equilibrium price, then stocks of that commodity should increase
(much like a government-imposed price floor can create a surplus). The
fact that stocks were declining, not building, in most commodity markets
from 2006-2008 is therefore an important contradiction of the price bubble
argument in these markets (see Korniotis (2009) and Pirrong (2010) for
detailed statistics and analysis). There are two possible counterpoints to
this observation. Caballero, Farhi, and Gourinchas (2008) argue that inven-
tory for an exhaustible resource like crude oil includes un-extracted oil in
the ground and it is possible that the below-ground rise in inventory more
than offset the above-ground (measured) decline in inventory. Hamilton
(2009b) notes that the buildup of (above-ground) inventories due to a
price bubble could be so small that it is not easily detected if the elasticity
of demand for the storable commodity is very small or zero.
The second factual inconsistency of the bubble story is that if index
fund buying drove commodity prices higher, then markets without index
fund investment should not have seen a price advance. Irwin, Sanders,
and Merrin (2009) show that markets without index fund participation
(fluid milk and rice futures) and commodities without futures markets
(apples and edible beans) also showed price increases during the
2006-2008 period. Stoll and Whaley (2010) report that returns for CBOT
wheat, KCBOT wheat, and Minneapolis Grain Exchange (MGEX) wheat
are all highly positively correlated from 2006-2009, yet only CBOT and
KCBOT wheat are used heavily by index investors. Stoll and Whaley also
observe that Commodity Exchange (COMEX) gold, COMEX silver,
New York Mercantile (NYMEX) palladium, and NYMEX platinum futures
prices are highly correlated over the same time period, but only gold and
silver are included in popular commodity indices. Pirrong (2010) reports
that the price of shipping services increased dramatically between June
2007 and July 2008 in concert with other commodity prices, which, he
argues, contradicts the bubble story since shipping services are non-
storable and therefore should not be susceptible to asset bubble influences.
There are two notable counterpoints to these observations. Petzel (2009)
argues that many of the comparisons are problematic because a bubble in
one market could be transferred to other markets through well-known
market linkages (i.e., cross-price elasticities).12 Tang and Xiong (2010)
point out that the relative magnitude of price increases for index and non-
index (storable) commodities is relevant whether or not non-index com-
modities increased in price.
12
Sanders, Irwin, and Merrin (2009) address this issue by selecting markets for comparison that have
low-cross price elasticities.
18
The third factual inconsistency with the bubble story is that speculation
was not excessive when correctly compared to hedging demands. The stat-
istics on long-only index fund trading reported in the media and discussed
at hearings tend to view speculation in a vacuum focusing on absolute pos-
ition size and activity. Working (1960) argued that speculation must be
gauged relative to hedging needs. In particular, speculation can only be con-
sidered “excessive” relative to the level of hedging activity in the market.
Utilizing Working’s speculative T-index, Sanders, Irwin, and Merrin (2010)
demonstrate that the level of speculation in nine agricultural futures
markets from 2006-2008 (adjusting for index fund positions) was not exces-
sive. Indeed, the levels of speculation in all markets examined were within
the realm of historical norms. Across most markets, the rise in index buying

was more than offset by commercial (hedger) selling. Buyuksahin and
Harris (2009) use daily data from the CFTC’s internal large trader database
to show that Working’s T-index in the crude oil futures market increased in
parallel with crude oil prices from 2004-2009, but the peak of the index was
still well within historical norms. Till (2009) reports similar results for crude
oil, heating oil, and gasoline futures from 2006-2009 using data in the
CFTC’s Disaggregated Commitments of Traders (DCOT) report.
The fourth observable fact that contradicts the bubble story relates to the
impact of index funds across markets; a priori, there is no reason to expect
index funds to have a differential impact across markets given similar pos-
ition sizes. In other words, one would expect markets with the highest
concentration of index fund positions to show the largest price increases.
But Irwin, Sanders, and Merrin (2009) find just the opposite when compar-
ing grain and livestock futures markets. The highest concentration of
index fund positions was often in livestock markets, which had the smal-
lest price increases through the spring of 2008. This is difficult to reconcile
with the assertion that index buying was responsible for a price bubble.
Empirical Evidence
We review here nine studies that do not provide empirical evidence of a
bubble and/or a statistical linkage between index fund activity and com-
modity futures price movements.13 As in the previous section, studies are
selected because they contain statistical analysis that directly tests whether
the recent commodity price spike contained a bubble component and/or
index fund trading contributed to the price spike. Most of the studies
focus on testing for a relationship between index fund trading and com-
modity futures price movements since this is the most direct type of
evidence.14
Buyuksahin and Harris (2009) use daily data from the CFTC’s internal
large trader database from July 2000-March 2009 to conduct a variety of
tests on the relation between crude oil futures prices and positions of
various types of traders. Granger causality tests provide no statistical evi-
dence that position changes (number of contracts) by any trader group
13
As before, we make no claim to presenting an exhaustive review of all such studies.
14
Though not reviewed here, Robles, Torero, and von Braun (2009) utilize weekly CIT data to conduct
Granger causality tests between index positions and futures returns. Despite the overwhelmingly nega-
tive results of their statistical analysis, the authors nonetheless assert that there is sufficient evidence
of the damaging role of speculation to warrant the creation of a new international organization to
counteract this market failure. See Wright (2009) for further discussion.
19
systematically precede price changes. This result holds for the entire
sample period, and when the sample is broken into two parts: from July
2000-June 2004 and July 2004-March 2009. Buyuksahin and Harris assume
that swap dealer positions are linked to commodity index investing, and
hence, the results for swap dealers are interpreted as a failure to reject the
null hypothesis of no relation between crude oil futures prices and index
fund trading.
A key question, then, is whether it is reasonable to assume that swap
dealer positions in crude oil futures accurately reflect the total effective
“demand” of index investors. As noted earlier, swap dealers internally net
long commodity index positions with other long and short
over-the-counter (OTC) positions. A 2008 CFTC report indicates that swap

dealer netting is substantial in crude oil, with only 41% of long swap
dealer positions in crude oil futures on three dates in 2007 and 2008 linked
to long-only index fund positions (CFTC 2008). Hence, the measurement
error inherent in using swap dealer positions to represent index fund pos-
itions in crude oil futures may be substantial and could limit the con-
clusions that can be drawn from studies like Buyuksahin and Harris.
Brunetti and Buyuksahin (2009) also use daily data from the CFTC’s
internal large trader database to analyze whether speculators destabilize
prices in five futures markets: NYMEX crude oil and natural gas, Chicago
Mercantile Exchange (CME) Eurodollar and mini-Dow, and CBOT corn.
The sample periods begin in either January 2005 or August 2006 (corn) and
end in March 2009. A unique feature of the study is that price impacts for
the five largest trader groups are estimated jointly in a vector autoregres-
sion (VAR) system, which allows tests not only of the direct effect of each
group on returns or volatility, but also the interaction of positions among
the groups. Three groups of speculators are considered: swap dealers,
hedge funds, and floor broker/traders. Like Buyuksahin and Harris (2009),
this study assumes that swap dealer positions represent commodity index
fund investments. Granger causality tests based on the estimated VAR
models yield two main conclusions. First, returns are not forecast by pos-
itions of any trader group in the five markets, including swap dealers, with
the exception of mini-DOW futures, where there is evidence of a dampen-
ing impact of hedge funds. Second, volatility is forecast by swap dealer
positions in crude oil and natural gas and by other speculators in all
markets except corn. Since the impact is negative, Brunetti and Buyuksahin
argue that speculators reduce risk in the futures market and therefore
lower the cost of hedging. Once again, the use of swap dealer positions to
represent index fund investment is a potential limitation of this study.
Stoll and Whaley (2010) use data from the CFTC’s weekly CIT report to
conduct a variety of tests on the null hypothesis that index fund trading
does not cause commodity futures price changes. The authors examine all
12 agricultural markets included in the CIT report from January 2006-July
2009: corn, soybeans, soybean oil, CBOT wheat, KCBOT wheat, feeder
cattle, lean hogs, live cattle, cocoa, cotton, coffee, and sugar. Granger caus-
ality tests between weekly futures returns and weekly index fund invest-
ment flows reject the null of no causality in only 1 of the 12 markets. The
authors also examine the contemporaneous relationship between returns
and changes in index fund investment flows after controlling for changes
in other speculator investment flows. A significant contemporaneous
relationship is found for only 2 of the 12 markets. Two additional “roll”
20
tests are conducted to determine whether the shifting of index fund pos-
itions between contracts impacts the relative price movements of the
nearest- and next-nearest futures contracts. This analysis is conducted for
six commodities tracked in the CIT report, as well as crude oil. These tests
find evidence of a significant relative price impact only in crude oil.
Overall, Stoll and Whaley conclude that commodity index investing has
little impact on futures prices.
Stoll and Whaley’s analysis generates virtually no evidence that index
trading had an impact on agricultural futures price movements. However,
it is not known whether their results generalize to a broader set of com-
modity futures markets, especially energy futures markets that have been
at the center of the current controversy. Another issue is that the power of

their statistical tests to reject the null hypothesis of no causality may be
decreased by the use of (U.S.) dollar flows to measure index fund partici-
pation. Dollar flow measures are computed by multiplying each week’s
net position (in contracts) by the price of the futures contract nearest-
to-expiration to obtain a total notional value, and then differencing the
total from week-to-week. Because U.S. dollar flows impound into activity
measures both the variability of prices and positions, it is a less precise
measure of actual index fund buying and selling. Finally, there is the
question of the degree to which the CIT data represents actual index
investment in agricultural markets. Sanders, Irwin and Merrin (2010)
show that the bulk of CIT positions are in fact swap dealers hedging OTC
exposure. However, swap dealers operating in agricultural markets
conduct a limited amount of non-index long or short swap transactions
(CFTC 2008), so there is less measurement error in using the net position
of swap dealers in these markets to represent index fund investment.
Sanders and Irwin (2010b) investigate the price impact of index fund
trading in four grain futures markets. Weekly CIT data for CBOT corn,
soybeans, wheat, and KCBOT wheat futures contracts from January 2004
to August 2009 are used in the analysis.15 The data from 2004-2005 are not
publicly available, and are used for the first time in this study. Extending
the sample period with this data is advantageous for two reasons. First,
previous research suggests that the buildup in index positions was most
rapid from 2004-2005 (Sanders, Irwin, and Merrin 2010); this period may
thus be the most likely to show the impact of index traders, if any.
Second, the additional two years of data increases the sample size of
weekly observations considerably compared to the publicly available CIT
data, which should improve the power of time-series statistical tests.
The data confirm that there was a fairly dramatic and large build-up in
index fund positions in the four grain markets examined by Sanders and
Irwin (2010b). For instance, the number of wheat contracts held by index
funds at the CBOT increased nearly fourfold from 2004 to 2006. However,
the buildup in index contracts and the peak level of index holdings pre-
dates the 2007-2008 increase in grain futures prices for which they are
blamed. This observation casts doubt on the hypothesis that index specu-
lation drove the 2007-2008 increase in grain futures prices. In 15 out of 16
tests, both Granger causality and long-horizon regressions fail to reject the
null hypothesis that commodity index positions (change in net long CIT
15
The same position data, updated through early September 2010, are used in figures 3-6 of this
article.
21
contracts or net long CIT contracts/total long market open interest) have
no impact on futures prices. Overall, the authors conclude that data trends
and statistical test results are not consistent with the widely-touted bubble
theory. A limitation of this study is that tests are restricted to four grain
futures markets.
Sanders and Irwin (2010c) investigate the price impact of index fund
trading in 12 agricultural markets and 2 energy futures markets (crude oil
and natural gas). Data compiled by the CFTC in the Disaggregated
Commitments of Traders (DCOT) report on positions held by swap dealers
from June 2006 to December 2009 is assumed to reflect index-type invest-
ments. Bivariate Granger causality tests are used to investigate lead-lag
dynamics between index fund positions and futures returns or price vola-

tility in each commodity futures market. In addition, a new systems
approach to testing lead-lag dynamics is introduced and applied. The
systems approach improves the power of statistical tests by taking into
account the contemporaneous correlation of model residuals across markets
and allows a test of the overall impact of index funds across markets.
The system of Granger-style causality tests fails to reject the null
hypothesis that trader positions do not lead returns in the 14 markets ana-
lyzed by Sanders and Irwin (2010c). Hence, there is no evidence of a
linkage between index trader positions (as represented by swap dealers)
in commodity futures markets and price levels. There is a tendency to
reject the null hypothesis that index trader positions do not lead to market
volatility. Similar to the results in Brunetti and Buyuksahin (2009), the
direction of the impact is consistently negative. While index positions lead
to lower volatility in a statistical sense, Sanders and Irwin (2010c) note that
it is possible that trader positions coincide with some other fundamental
variable that is actually causing the lower market volatility (see the discus-
sion of Newbold (1982) above). Sanders and Irwin (2010c) are also aware
that swap dealer positions may be an imperfect proxy for overall index
investments due to internal netting of OTC positions by swap dealers, par-
ticularly in the energy futures markets. However, they argue that the net
position may still be relevant with respect to price impacts since this is the
position actually taken to the commodity futures market. Whether netted
or non-netted positions are more relevant is an empirical question.
Irwin and Sanders (2010) conduct a test of the “Masters Hypothesis” in
commodity futures markets using the newest of the CFTC’s data series on
index fund investment – the quarterly Index Investment Data (IID) report.
The IID data is not only a better measure of index investment because pos-
itions are measured before internal netting by swap dealers, it also covers
the complete spectrum of agricultural, energy, metal and soft commodity
futures markets. A cross-sectional regression test is applied to the IID data
over the first quarter of 2008 through the first quarter of 2010, which cap-
tures the rapid increase, peak, and subsequent decline in commodity
prices. A cross-sectional approach is likely to improve statistical power
compared to time-series Granger-type tests (Sanders and Irwin 2010a) and
a quarterly horizon should better capture a slowly accumulating price
pressure effect if it is present in the data. Both lagged and contempora-
neous effects are also considered.
Irwin and Sanders’ regression estimates provide very little evidence that
index positions influence the cross-section of 19 commodity futures
market returns or volatility. Only 3 of the 18 average estimated slope
22
coefficients are statistically significant, and 2 of the 3 significant cases have

negative signs that contradict the claim that index investment increases
returns or volatility. The results are robust regarding whether lagged or
contemporaneous effects are considered. The cross-section tests are sup-
plemented with time-series tests using daily positions held by the U.S. Oil
and Natural Gas Funds, two of the largest exchange-traded index funds
(ETFs), in the crude oil and natural gas futures markets, respectively.
Granger-causality tests show no causal links between daily returns or
volatility in crude oil and natural gas futures markets and the positions of
the two large ETFs. Long-horizon regression tests likewise fail to reject the
null hypothesis of no market impact for the ETFs. Overall, the empirical
results of the study fail to support the hypothesis that index funds were a

major driver of the recent spike in commodity prices.
Irwin et al. (2011) examine whether index funds were responsible for
recent episodes of non-convergence between CBOT corn, soybean, and
wheat futures prices and cash prices during the delivery period of the
contracts. Some argue that index funds were a major driver of the epi-
sodes of non-convergence because index fund investment put upward
pressure on the spreads between futures prices for the same commodity
due to the “rolling” of positions or the initiation of positions in a
“crowded market space” (e.g., USS/PSS 2009; Petzel 2009). If spreads
approach full storage and interest opportunity costs, an incentive is
created for those taking delivery that effectively de-couples cash and
futures prices. The authors do not find evidence of a statistically signifi-
cant increase in spreads during the roll window of index funds. Whether
lagged or contemporaneous effects are considered, Granger causality tests
fail to find a statistically significant link between weekly positions of index
funds and movements in spreads. Irwin et al. conclude that other factors
must be responsible for the non-convergence between cash and futures
prices.
Buyuksahin and Robe (2010) investigate the source of the recent increase
in correlation between stock and commodity returns. The authors first
document that the correlation between commodity (S&P-GSCI) and stock
index returns (S&P 500 IndexTM ) from January 1991 to August 2008 gener-
ally fluctuated between -0.40 and 0.40. Almost immediately after the col-
lapse of Lehman Brothers in September 2008, the correlation spiked as
high as 0.70 and remained at historically high levels until March 2010.
Buyuksahin and Robe utilize disaggregated data from the CFTC’s large
trader reporting system to test whether the market activity of different
groups of traders in commodity futures markets is helpful in explaining
the increasing correlation. After accounting for business cycle and other
economic factors, only hedge fund activity is a significant factor. In con-
trast to Tang and Xiong (2010), no evidence is found that index fund
activity (as measured by swap dealer positions) is associated with the
increasing correlation between commodity and stock returns.16 The differ-
ence in results is likely due to the detailed information on trading activi-
ties of all major participants in commodity futures markets used by
Buyuksahin and Robe.
16
Silvennoinen and Thorp (2010) also investigate the source of increasing correlation between commod-
ity and financial returns and reach similar conclusions to Buyuksahin and Robe (2010).
23
Kilian and Murphy (2010) estimate the price elasticity of crude oil (and
gasoline) demand because theory indicates a zero or near zero price elas-
ticity of demand is required for speculation to impact spot prices in a stor-
able commodity market (see Hamilton 2009b). The authors develop a
structural VAR (vector autoregression) model of the global market for
crude oil that explicitly allows for shocks to the speculative demand for
crude oil, as well as shocks to the flow demand and flow supply. Their
median estimate of the short-run price elasticity of demand for crude oil is
-0.41, which is about seven times higher than typical conjectures in the
recent literature. In a related fashion, the median estimate of the short-run
price elasticity of demand for gasoline is -0.20, several times higher than
previous estimates. Since the short-run elasticity estimates are substan-

tially larger than zero (in absolute terms), Kilian and Murphy conclude
that speculation did not play a major role in the run-up in crude oil
prices. The model estimates imply that the surge in crude oil prices from
2003-2008 was caused by fluctuations in the flow demand for oil driven by
the global business cycle. As with all structural modeling exercises, Kilian
and Murphy’s structural VAR model depends on a fairly lengthy list of
identifying restrictions. The impact of these restrictions on elasticity esti-
mates will undoubtedly be the subject of further research.
Overall, the results of the studies reviewed in this section provide no
systematic evidence of a relationship (statistically or economically)
between positions of index funds and the level of commodity futures
prices or spreads between commodity futures prices. This finding is con-
sistent across a variety of commodity futures markets, measures of index
fund activity, statistical tests, sample periods, and time horizons. Of par-
ticular note is the robustness of the results across combined on- and
off-exchange index fund positions, netted or non-netted swap dealer pos-
itions, and individual ETF positions. It should also be noted that the lack
of a relationship is consistent with the majority of academic evidence per-
taining to speculation and price behavior (e.g., Petzel 1981; Sanders, Boris,
and Manfredo 2004; Bryant, Bessler, and Haigh 2006; Sanders, Irwin, and
Merrin 2009). Finally, there is mild evidence of a negative relationship
between index fund positions and the volatility of commodity futures
prices, consistent with the traditional view that speculators reduce risk in
the futures market and therefore lower the cost of hedging.
Summary and Conclusions

Investment in long-only commodity index funds soared over the last
decade. This surge and its attendant impacts have been labeled the “finan-
cialization” of commodity futures markets. In view of the scale of this
investment – at least $100 billion – it is not surprising that a worldwide
debate has ensued about the role of index funds in commodity futures
markets. Those who believe index funds were responsible for a bubble in
commodity futures prices (e.g., Masters 2008) make what seems to be an
obvious argument – that the sheer size of index investment overwhelmed
the normal functioning of these markets. Those who do not believe index
funds were behind the run-up in commodity futures prices in recent years
point out logical inconsistencies in the bubble argument, as well as several
contradictory facts (e.g., Irwin, Sanders, and Merrin 2009; Pirrong 2010).
24
Not surprisingly, a flurry of studies has been completed recently in an

attempt to sort out which side of the debate is correct. One group of
studies finds evidence that commodity index investment directly or
indirectly had an impact on commodity futures prices (Gilbert 2009, 2010;
Einloth 2009; Tang and Xiong 2010). Results in these studies negate the
argument that no evidence exists of a relationship between commodity
index investment and movements in commodity futures prices. However,
the data and methods used in these studies are subject to a number of
important criticisms that limit the degree of confidence one can place in
their results. Another group of studies fails to find systematic evidence of
a relationship (statistically or economically) between positions of index
funds and the level of commodity futures prices (Buyuksahin and Harris

2009; Brunetti and Buyuksahin 2009; Stoll and Whaley 2010; Sanders and
Irwin 2010a, 2010b, 2010c; Irwin and Sanders 2010; Buyuksahin and Robe
2010). The results are robust across combined on- and off-exchange index
fund positions, netted or non-netted swap dealer positions, and individual
exchange-traded fund (ETF) positions, as well as a variety of statistical
tests, sample periods, and time horizons.
Even if one ignores the data and methodological concerns in the first
group of empirical studies, the weight of the evidence is not consistent
with the argument that index funds created a bubble in commodity futures
prices. Whether the wave of index fund investment simply overwhelmed
normal supply and demand functions (Masters 2008), channeled investors’
views about commodity price directions (Gilbert 2010), or integrated finan-
cial and commodity markets (Tang and Xiong 2010), the linkage between
the level of commodity futures prices and market positions of index funds
should be clearly detectable in the data. Very limited traces of this linkage
are visible, however. To date, no “smoking gun” has been found.
Moreover, results of studies that test for a bubble component in commodity
futures prices – regardless of the cause – are decidedly mixed (Gilbert
2009; Phillips and Yu 2010; Kilian and Murphy 2010). Therefore, it is
unclear if there was a bubble in commodity futures price from 2007-2008,
and even less clear whether one was caused by index funds.
From this perspective, the current controversy surrounding index funds
can be viewed as simply the latest in a long history of attacks upon specu-
lation in commodity futures markets (Jacks 2007). For example, Labys and
Thomas (1975, p. 287) investigated the 1973-75 commodity boom and
described the situation in terms remarkably similar to the present contro-
versy, “This paper analyses the instability of primary commodity prices
during the recent period of economic upheaval, and determines the extent
to which this instability was amplified by the substantial increase in
futures speculation which also occurred. Of particular interest is the
degree to which this speculation rose and fell with the switch of speculat-
ive funds away from traditional asset placements and towards commodity
futures contracts.” While index funds have become sizable participants in
commodity futures markets, there is once again precious little evidence
that these “new speculators” drove price movements.
Important implications for public policy follow from the conclusion that
index funds were not a primary driver of the 2007-08 commodity price
boom. New limits on speculation are not grounded in well-established
empirical findings and could impede the price discovery and risk-shifting
functions of these markets. In particular, limiting the participation of
25
index fund investors would diminish an important source of risk-bearing

capacity at a time when such capacity is in high demand. Commodity
futures markets would become less efficient mechanisms for transferring
risk from parties who don’t want to bear it to those that do, creating
added costs that ultimately get passed back to producers in the form of
lower prices and back to consumers as higher prices. Moreover, new
speculative position limits in futures may simply push index fund inves-
tors into physical commodity markets (Kaminska 2010), where index
investments would not be subject to speculative futures position limits.
Index fund positions in physical (cash) markets would provide a much
more direct means by which financial investors could impact price discov-
ery and stockholding in commodity markets; seemingly not the desired

outcome of the regulatory drive to limit futures speculation.
There are several issues related to the 2007-2008 spike in commodity
prices that merit further investigation. First, a number of potential expla-
nations for the spike have been offered beyond speculation – including
demand growth from China and other developing economies, biofuel pol-
icies, monetary policy, trade restrictions, and supply shortfalls – but there
is no consensus about their relative impacts. While some researchers have
begun to tackle this question (e.g., Frankel and Rose 2009; Kilian and
Murphy 2010; Martin and Anderson 2010; Heady and Fan 2010), much
more effort is needed before a clear consensus can be reached. Second,
even if index funds did not affect the level of commodity futures prices,
this does not preclude other impacts. A logical place to investigate is the
market for storage. Classical economic writers such as Cootner (1961) and
Weymar (1968) argued that the introduction of futures trading in a com-
modity market flattens the supply of storage curve because the activity of
futures speculators increases risk-carrying capacity. It is not unreasonable
to posit that the large-scale addition of index investors increased stock-
holding capacity in a similar fashion, a point made by Verleger (2009)
with respect to crude oil. The available evidence on index funds’ impact
on the market for storage has so far been limited to time-series analysis of
the behavior of futures spreads (Stoll and Whaley 2010; Irwin et al. 2011).
Research is needed that investigates possible structural impacts on the
supply and demand for storage in commodity markets. Third, the “finan-
cialization” of commodity futures markets generally has been defined in
terms of the rise of commodity index funds. The emerging evidence
(Etula 2009; Buyuksahin and Robe 2010) indicates that other types of
traders, such as broker-dealers and hedge funds, play key roles in trans-
mitting shocks to commodity futures markets from other sectors. This is a
promising avenue for increasing our understanding of the pricing
dynamics in commodity futures markets.
Acknowledgements
The authors thank Kevin Norrish of Barclays Capital for providing data on assets
in commodity index funds. Nicole Aulerich, Jean Cordier, Linda Fulponi, Jim
Hamilton, Todd Petzel, Aaron Smith, Carl Zulauf and participants in the OECD
Working Party on Agricultural Policies and Markets provided helpful comments
on earlier versions of this article.
26
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Applied Economic Perspectives and Policy (2011) volume 33, number 1, pp. 1– 31.

Scott H. Irwin is the Lawrence J. Norton Chair of Agricultural Marketing,

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Submitted March 2009; accepted December 2010.

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This line of reasoning fueled political pressure to limit speculative pos-

related production shortfalls are cited, as well as demand growth from

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These statements illustrate the acrimonious and heated nature of the

Commodity Index Funds

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Figure 1 Flow of index investments into commodity futures markets

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(O’Hara 2008), it is largely consistent with popular notions. That is, a

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Based on these findings, the Subcommittee recommended the: 1) phase

as a position limit of 5,000 contracts per trader; 3) investigation of index

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In essence, Petzel (2009) argues that unleveraged futures positions of

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Einloth (2009) devises a test of bubbles based on the joint behavior of

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increase in correlation of commodity futures returns with stock, bond, U.S.

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against “mildly explosive alternatives” that would characterize a bubble.

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It Was Not a Bubble

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The implication is that the interplay between varied market participants is

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coefficients are statistically significant, and 2 of the 3 significant cases have

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Summary and Conclusions

Not surprisingly, a flurry of studies has been completed recently in an

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index fund investors would diminish an important source of risk-bearing

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———. 2010. No Theory? No Evidence? No Problem! Regulation. (Summer): 38–44.

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Wright, Brian. 2009. International Grain Reserves and Other Instruments to

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