A Ponzi scheme is defined as a phony investment program where the introduction of new funds is used to create “profits” for those already in the game. Ponzi schemes typically have some purported economic rationale for the profits, but at the end of the day, the basis is shown to be a sham as well. This is a pretty good description of Wall Street’s commodities-as-an-asset class machinations.
Wall Street positioned long-only commodity index investing as a core asset class and critical diversification. Investors piled into this strategy, particularly in the first half of last year, with total participation estimated to have peaked around $300 Billion. These inflows drove prices higher which produced positive returns for earlier investors, leading to yet more investors becoming attracted, again driving up prices, creating a vicious cycle analogous to a classic pyramid. Unlike a true Ponzi scheme, it was not just the investors who ultimately were harmed, but the economy as a whole. Mike Masters and Adam White recently released a report chronicling the damage done to the economy by the commodity bubble fueled, at least in part, by the participants in this investment strategy. The damage easily exceeds $100 Billion.
Given the damage done, it’s more than fair to ask whether the commodity-as-asset-class strategy had any legitimacy to begin with. As I’ve written before about this approach, just because you can run numbers through a model doesn’t mean they make sense. The core rationale for Wall Street’s commodity “pitch” was the argument that commodities provided unique portfolio exposure. The chart below brings this key argument into question.
The chart shows the 5-year price history of the Reuters Jefferies CRB index (black), a broad index of commodity futures, versus the Morgan Stanley Commodity Related Equities Index (purple), an equal weighted index of 20 equities whose core businesses are linked to commodities. The high correlation (roughly 80%) shows that portfolio managers can capture the portfolio characteristics of commodities by using stocks. In fact, running a more robust set of analytics over longer periods suggest that the equity approach is actually superior — what it loses in correlation is gained in better protection in downturns. Finally, the stocks in this index have an average dividend yield of roughly 2.6%. The much hyped “roll yield” of commodities is now negative, and significantly so for energy-oriented indices like the popular S&P-Goldman Sachs Commodity Index.
So why the rush into commodity futures? In the industry it’s been said that, “some products are bought and some products are sold.” The manufacture and distribution of products tied to commodity futures (swaps, structured notes, etc.) is far more profitable that the penny-per-share stock business. It should be no surprise that Wall Street’s investment banks sought to highlight and promote a lucrative product at the expense of a more effective strategy. Nor should it be a surprise that these same firms are fighting the restoration of traditional market rules which might have prevented these market distortions.
The Ponzi scheme analogy is an imperfect comparison of course. The Wall Street firms which promoted commodities in this manner put the money into the markets as promised and no laws were broken. However, this should not deter our policymakers from understanding the true nature of the strategy — it was built on flawed assumptions and Wall Street hype. Like anything else built on bad ideas, bad consequences have been the inevitable result. Congress is in the early stages of considering legislation that would help, The Derivatives Markets Transparency and Accountability Act of 2009. Let’s hope we can construct barriers that will prevent a repeat of the 2008 debacle.