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TED BUTLER COMMENTARY

January 16, 2007

CHANGING OF THE GUARD?

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

The King Is Dead…

Long Live The King.

Perhaps it is too soon to utter those words definitively, but there appears to be a remarkable change in order taking place that promises to impact silver investors favorably. It involves the world of hedge funds. One type of fund is, apparently, on the descent and another type seems to be ascending.

Recent statistics and data suggest that the tech funds (technical futures trading funds) that I have long written about are losing market clout and relevance, due to trading losses and investor withdrawal of capital. Long time readers know that I have referred to these tech funds as "brain-dead" in the past and have lamented that they are an integral part of the large dealer short manipulation. I characterize them as brain dead, not so much as to be insulting, but to describe their mechanical approach to buying and selling.

I complained that, without these tech funds allowing themselves to be bamboozled by the dealers, the prime motivation for the dealers continuing the manipulation would cease to exist, and with that cessation, perhaps the manipulation itself. I’ve never been much of a deep conspiracy guy, and I’ve always felt that the manipulation continued because the dealers were taking money from the tech funds. But you can’t get blood from a stone, and funds may have suffered serious enough depletion of capital to suggest that they won’t be the cash cow for the dealers that they have been in the past.

The release of year-end data from what I believe to be the largest futures tech fund, John W. Henry & Co. (www.jwh.com), suggests that the tech fund well may be running dry for the dealers. On balance, the year 2006 produced negative returns, as was the case for the two prior years. The annual three year total trading loss was around -7%, meaning more than 20% was lost over the past three years. Due to investor withdrawals, combined with those trading losses, assets under management are close to 45% below historic highs. These results were achieved, paradoxically, during an unprecedented commodity price boom.

For the record, I am not celebrating that these losses have occurred, and wish neither John W. Henry & Co nor their investors any further losses. I just want to analyze what happened and what the impact may be for silver. I am assuming, of course, that the results for Henry parallel, somewhat, the results for other such tech funds.

The first observation is that due to the erosion in assets under management, the size of future trading positions will be necessarily smaller, because these funds abide by rigid money management guidelines. In addition, and maybe more importantly, the volatility of silver prices has further reduced trading position size. This reduction in silver position size is confirmed by Commitment of Trader Report (COT) data.

My conclusion is that these smaller tech fund trading positions may not be a flash in the pan, and may detract from future dealer control, or rigging, of the silver market. At some point, the incentive to rig prices may diminish to the point that the silver manipulation is terminated. That will truly be a great day.

If the tech funds’ star is waning, another type of fund, the index fund, is rising. Index funds are very different from the tech funds in that they don’t trade near as much. The index funds basically buy and hold. As such, they are more aligned with the best interests of silver investors.

Index funds are passive institutional pools of money that attempt to replicate the performance of well known commodity indices, principally the Goldman Sachs Commodity Index (GSCI) or the Dow Jones-AIG Commodity Index (DJ-AGICI). They are big business, with investments running into the many tens of billions of dollars.

Just how big the index funds have become was recently revealed with the release of COT supplemental report, which commenced on January 8. This report covers 12 agricultural commodities (not silver) and breaks down, for the first time, how many contracts are held by the index funds. In a word, they hold a lot. I was genuinely surprised by how many contracts they held.

These index funds, as expected, were almost exclusively on the long side. As a subset of the commercial category, they held a larger and more dominant position than any other category in just about every market. In many markets, the long position of the index funds exceeded the long position of two, or all, of the other long position categories (commercial, non-commercial and non-reporting) combined. That’s big.

While the index funds’ positions were extremely large, and necessitated an equally large short position being created to allow it to exist, it should be mentioned that these funds will not stand for physical delivery, creating a short squeeze. In a delivery crunch, caused by outside influences, however, it is not hard to imagine incredible financial pressure being brought to bear on short sellers in general, due the index funds presence.

What does this have to do with silver? Well, silver is represented in both the major indices, with a very small 0.31% weighting in the GSCI and a 2.29% weighting in the DJ-AIGCI. But based upon those weightings and comparable weightings in these indices for the commodities covered in the COT supplemental report, it appears obvious that there is not a noticeable presence in the COMEX silver futures market by the index funds. In other words, while it is clear that index funds have a distinct and dominant position in the corn, soybean and sugar futures markets, for example, it is equally clear they don’t have a meaningful position in silver futures. What does this mean?

To me, it means that the index funds are holding their silver weightings in some other form, other than futures contracts. I think they are principally holding it in the silver ETF, making up a big chunk of the 122 million ounces, or $1.5 billion, holdings of the ETF. If I am correct, this is significant because buying the actual commodity has more impact on price than futures contracts on that commodity. For instance, if the index funds did, or could buy 2 billion bushels of corn, instead of that equivalent in the futures contracts that they did buy, that would have a (more) profound impact on price (than it has already).

The good news for silver investors is that buying by the index funds of the ETF is better than buying of futures contracts. That the tech funds are fading as the index funds emerge is a beneficial development for silver investors. It will contribute to a price rise. As they say, out with the old, in with the new.