The Anatomy of a Commodity Index - dummies

By Amine Bouchentouf

As an investor interested in making money through index investing, you have five commodity indexes at your disposal. Although the composition and structure of every index is different, the aim is the same: to track a basket of commodities. Before you get into specific commodity indexes, watch out for these pitfalls when shopping for an index:

  • Components: Each index follows a specific methodology to determine which commodities are part of the index. Some indexes, such as the S&P GSCI, include commodities based on their global production value. Other indexes, such as the DBLCI, include commodities based on their liquidity and representational value of a component class, such as picking gold to represent metals and choosing oil as a representative of the energy market.

  • Weightings: Some indexes follow a production-weighted methodology, in which weights are assigned to each commodity based on its proportional production in the world. Other indexes choose component weightings based on the liquidity of the commodity’s futures contract. In addition, some weightings are fixed over a predetermined period of time, whereas others fluctuate to reflect changes in actual production values.

  • Rolling methodology: Because the index’s purpose is to track the performance of commodities and not take actual delivery of the commodity, the futures contracts that the index tracks must be rolled over from the current-month contract to the front-month contract (the upcoming trading month). Because this rolling process provides a roll yield (a yield that results from the price differential between the current and front months), you need to examine each index’s policy on rolling. You can find this information in the index brochure.

  • Rebalancing features: Every index reviews its components and their weightings on a regular basis to maintain an index that reflects actual values in the global commodities markets. Some indexes rebalance annually; other indexes rebalance more frequently. Before you invest in an index, find out when it’s rebalanced and what methodology it uses to rebalance.

Although each index is constructed differently, all indexes have to follow certain criteria to determine whether a commodity will be included in the index:

  • Tradability: The commodities have to be traded on a designated exchange and must have a futures contract assigned to them.

  • Deliverability: The contracts that go into the index must be for an underlying commodity that has the potential to be delivered. This eliminates the inclusion of futures contracts that represent financial instruments, such as economic indicators, interest rates, and other “financials.”

  • Liquidity: The market for the underlying commodity has to be liquid enough to allow investors to move in and out of their positions without facing liquidity crunches, such as not being able to find a buyer or seller.