Why Commodity Indexes Are Useful - dummies

By Amine Bouchentouf

A commodity index tracks the price of a futures contract of an underlying physical commodity on a designated exchange. When you invest through one of the commodity indexes, you’re actually investing in the futures markets.

Indexes are known as passive, long-only investments, for two reasons: No one is actively trading the index, and the index tracks only the long performance of a commodity. It doesn’t track commodities that are short (a sophisticated strategy meant to profit when prices go down).

Is it indexes or indices? Both are correct. Dow Jones, which has its own commodity index, spells the plural form of index as indexes. On the other hand, Standard & Poor’s, which also has a commodity index, spells the plural form as indices. No matter how you spell them, though, at the end of the day, indexes and indices refer to the same thing.

Using commodity indexes is a good way to determine where the commodity markets are heading. Just as stock indexes allow you to identify broad market movements (which then enables you to implement and update your investment strategy accordingly), commodity indexes give you a way to measure the broad movements of the commodities markets.

In essence, a commodity index gives you a snapshot of the current state of the commodities market. You can use an index in one of three ways:

  • Benchmark: You can use a commodity index to compare the performance of commodities as an asset class with the performance of other asset classes, such as stocks and bonds.

  • Indicator: You can use the commodity index as an indicator of economic activity, possible inflationary pressures, and the state of global economic production.

  • Investment vehicle: Because a commodity index tracks the performance of specific futures contracts, you can replicate the performance of the index by trading the contracts it tracks. You can invest in a commodity index both directly (by buying the contracts) and indirectly (via mutual funds).