The $300 Billion Ponzi Scheme

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. 

Commodity Futures vs. Commodity-Related Equities

Commodity Futures vs. Commodity-Related Equities

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.

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6 Responses to “The $300 Billion Ponzi Scheme”

  1. mxq Says:

    during a crisis (and as we all saw first hand) correlations of every asset class inevitably move towards “1.” The potential for unintended consequences are notoriously absent from academic studies that tout the virtuousness of commodity as an asset class. Just like abs…in theory it sounds great…but “theory” has tons of assumptions that inevitably prove to be nuts (i.e. real estate doesn’t depreciate; commodities aren’t correlated with subprime mtgs, etc..)

  2. wel Says:

    Agree with the thesis of this article, but have a couple questions (comments). First, the graph shows CRX and CRB on different scales. On the same scale things look very different. The CRB peaked in 2008 up 75% from 2/04 while CRX peaked up almost 200%. Since then, the CRB has fallen to about negative 15% compared to 2/04 – a fall of -90% from the peak. CRX fell to about +50% up from 2/04, a fall of nearly 150% from the peak. So it’s pretty clear that commodity equities went up further and fell harder over the last 5 years. The correlation between commodity equities and the CRB is about 80% over the past 5 years, but this is skewed higher than the historical average of about 55% because everything crashed together in 2008. Even with the higher correlation between commodities and commodity stocks over the last year, the correlation between commodity stocks and the total market has been about 65%, as opposed to only 36% between commodities and stocks.

  3. Jeff Korzenik Says:

    wel’s points are excellent. thank you. the main point, as I think wel recognizes, is to show that at least some of the portfolio characteristics of including commodities can be replicated. To my thinking, the greater sensitivity of commodity related equities means that they should have a lower overall allocation in a portfolio mix than commodity indices.
    More serious is the issue of the changing correlations between commodities and stocks. I haven’t written up the background work on this yet, but correlations don’t tell the whole story. Essentially, commodity related stocks correlate more closely with equities when commodities are going down and stocks are going up, so a higher correlation to equities is actually a good thing from an overall portfolio management standpoint. In other words, when you’d want commodities in the portfolio, commodity related equities perform well, and when you wouldn’t want commodities in a portfolio, commodity related equities are at least superior. Over the next few weekes, I’ll try to get something out that gives the full picture. Thanks again for the thoughtful comments.

  4. Another Reason Oil Prices Are Falling? « (in)efficient frontiers Says:

    […] inflating oil prices, it needs a constant inflow of new money to sustain those prices, just like a Ponzi scheme needs new funds to keep the game going.  It’s hard to imagine money managers continuing […]

  5. Fundamental Misconceptions in the Speculation Debate « (in)efficient frontiers Says:

    […] products.  This is simply a myth promulgated by Wall Street marketing departments.  As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked […]

  6. Some Stocks Could Benefit from CFTC Restrictions « (in)efficient frontiers Says:

    […] Those same product pushers are likely to rediscover that which has always been true — certain commodity related equities offer similar or superior portfolio characteristics to the underlying […]

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