I think I’ve followed you so far but ... why not the hedge funds ? If Goldman Sachs is running the hedge fund, doesn’t that count as a “big spec” ? If not why not ? (trying to learn something here!)
Thanks for all your info.
The problem occurs when a big pension fund -- say, CALPERS -- approaches G-S and says something like, ''We want to balance our asset portfolio and put 5% (or whatever amount) into commodities''.
The first problem is that CALPERS is subject to ERISA regulations (if/when the goobermint decides to enforce them, which is a separate question, of course...). As such, they are barred from participating in a number of areas, and commodity futures is one of them. The ''prudent man'' rule, and all that stuff, right?
So, what G-S does is to engineer an end run around the regulations. CALPERS **can** trade indicies, S&P 500 and Russell 2000 and whatnot, and G-S create an index product for them, or invest them in one of Goldman's existing index products.
CALPERS puts up 100% of the notional value of the index product, whatever it happens to be, because they are tightly limited as to the use of leverage. G-S allots 10% or so of CALPERS' stake (whatever is a mkt-competitive ''margin'' percentage) to the index product in question, takes a fee (of course), and puts the remainder into T-Bills or some similarly risk-free or nearly risk-free instrument.
In effect, CALPERS doesn't lever itself here, but Goldman does it for them. And this is the second problem. Leverage-by-proxy is not, afaik, prohibited. It certainly should be, however, because if the index product goes south, which is hardly an impossible occurrence, CALPERS will lose some sizeable proportion of its initial stake, T-Bills or no. It doesn't matter who is **doing** the levering; what matters is the effect on the capital stake should the levered instrument misperform, ok?
The third problem also stems from the way CALPERS is regulated. An index product -- ANY index product -- is what is called LOSO, or 'Long Side Only', because pension funds et al. are barred from selling anything short (reasonably enough).
Now, CALPERS by itself isn't any sort of problem. It's huge, to be sure, but so are many futures mkts. The problem occurs when LOTS of pension funds do this, because their capital base -- even the 5% or 8% or whatever portion they want to put into commodities -- can and does ultimately overwhelm the mkts in which they participate.
Net-net, what happens is that a given mkt or mkts, in the present case crude oil and products, sees an enormous infusion of capital, and every dollar of the new capital is on the long side of the market.
Now, here's your final exam for this little course in Index Futures 201:
Under these conditions, what MUST happen to the price of the affected markets, and why is this type of 'investment' a long-term problem for the US (and world) economy?
500 words or less.
I hope the explanation above is sufficiently clear. If not, please say so, and I'll elabourate a bit more. FReegards to you!