The impact of commodity funds on grain and livestock prices is for real. The sharp increase in money that has flowed into commodity funds in the last three years is overwhelming. It's important, however, to recognize the difference between a regular commodity fund and a commodity index fund.

The influx of commodity index funds increased dramatically in just the last two years. Prior to that, standard commodity funds, which can be both long or short a market, were the major players. From 2001 to the end of 2005 the amount of money in commodity funds increased from about $40 billion to $130.5 billion. Contrary to popular belief, the amount of money in regular commodity funds actually declined in 2005 because the majority of commodity funds lost money.

But now along come index funds, which are only long in the market. It's our estimate that the amount of money in index funds now is fairly equal to the amount of money in regular commodity funds. The reason for the rapid rise in index funds focuses on two primary reasons.

First, there's the attitude among financial consultants that wealthy investors and institutions should diversify their investment portfolios and not concentrate only on stocks, bonds, real estate, etc. Part of that mix is to be in commodities — and only on the long side. It's their belief that the world is in a long-term inflationary trend that will eventually push all commodity prices higher.

The second change that has occurred in the last year is the sharp increase in position size that individual investors and funds can now establish in the grain markets.

For example, a year ago the largest position a fund could take in the corn market was 45 million bushels. On June 10, 2005, that was increased to 77.5 million bushels and on Dec. 10 increased to 110 million bushels. For a fund with several billion dollars to invest, the returns both plus and minus on only 45 million bushels were too small to justify spending any time on that particular market. Now that the limits have been raised, the interest has increased.

The granddaddy of all index funds is the Goldman Sach's Commodities Index (GSCI), which at the time of this writing contains about $55 billion. Note that 74% of the fund is invested in energy markets and only 7% in the grain market.

The Rogers Commodity Index contains approximately $5 billion, the Dow Jones AIG Commodity Index about $24 billion and the Reuters/Jefferies CRB Index has less than $500 million. The Deutsche Bank Liquid Commodity Index (DBLCI) is relatively new and difficult to obtain data on exactly how large this fund is. Our best guess, however, is that it could be close to the size of the GSCI.

In the DBLCI, note that 55% of the fund is invested in energy. The fund trades only six commodities that include crude oil, heating oil, aluminum, gold, wheat and corn. This would account to some degree for the extreme volatility in the corn and wheat markets during the first three months of this year.

Where To From Here?

The next six months are going to be important in determining the longevity of index funds. Since the majority of their assets are committed in the energy market, the success of these funds is likely going to be determined by whether the energy markets can maintain an upward price bias.

No matter how bullish people are on commodities long term, this remains a cyclical business. What goes up will come down. If prices continue lower, the question becomes how long will investors in index funds continue to lose money before pulling the plug?

Should prices trend down, we estimate that interest in index funds will start to fade by the middle of this year.

The funds are an emotional subject for many people. Unfortunately, some believe the funds will help support commodity prices for a long time. It's my opinion that this theory will prove to be a disappointment and that the usefulness of supporting grain prices by index funds will eventually disappear.

Richard A. Brock is president of Brock Associates, a farm market advisory firm, and publisher of The Brock Report. For a trial subscription and information on Brock services, call 800-558-3431 or visit www.brockreport.com.