Index Investing and the Financialization of
and Wei Xiong
This paper examines the financialization process of commodities precipitated by
the rapid growth of index investment to the commodities markets since the early
2000s. We find that concurrent with the increasing presence of index investors,
commodity prices have been increasingly exposed to market-wide shocks, such as
shocks to the world equity index and US dollar exchange rate, and to shocks to
other commodities, such as oil. In particular, this trend is more pronounced for
commodities in the two popular commodity indices, the GSCI and DJ-AIG
indices. As a result of the financialization process, the spillover effects of the
recent financial crisis contributed substantially to the large increase in commodity
price volatility in 2008. Our study thus highlights the increasingly important
interactions between commodities markets and financial markets.
The dramatic rise and fall of crude oil prices in 2008 (as shown in Figure 1) has stimulated
increasing public attention and research interest in commodities markets. In particular, there is
heated debate in policy circles about whether speculation caused unwarranted increases in the
cost of energy and food and induced excessive price volatility. Both the Senate and the House
have held hearings about this issue. Recently, the U.S. Commodity Futures Trading Commission
(CFTC) said it would consider new measures to curb speculation. The surge in oil prices even
prompted UK Prime Minister Gordon Brown and French President Nicolas Sarkozy to write a
joint Wall Street Journal editorial in July 2009 to urge joint effort by international governments
to supervise the energy markets.
The ongoing debate attributes the recent rise and fall of oil prices either to a simple matter of
supply and demand or to excessive speculation by index investors. According to the first view,
which is emphasized by many economists, e.g., Krugman (2008), Hamilton (2009), and Kilian
PRELIMINARY. This draft: September 2009. We wish to thank Nick Barberis, Alan Blinder, Markus
Brunnermeier, Ing-Haw Cheng, Zhiguo He, Han Hong, Alice Hsiaw, Arvind Krishnamurthy, Tong Li, Burt Malkiel,
Bob McDonald, Lin Peng, Mark Watson, and seminar participants at Princeton University for helpful discussion and
Renmin University of China, Email: firstname.lastname@example.org.
Princeton University and NBER, Email: email@example.com.