Sift through the Different Commodity Indices - dummies

By David Stevenson

Investing in commodities is relatively straightforward after you get a grip on the issue of spot versus futures prices. Instead of bravely towing an oil tanker out off the coast of Saudi Arabia and touting for physical deliveries, you sit quietly at home in the UK in front of a computer and invest in commodity markets tracked by major indices.

These commodity indices come in all shapes and sizes. The most popular choice is a bunch of major composite indices that include a wide series of individual commodities ranging from oil to pork bellies.

But you can also drill down into even greater detail if you choose — some investors want to buy only hard commodities outside energy (say, metals) whereas others want to invest in agricultural commodities but not include wheat.

For many investors a broad composite index isn’t quite good enough. They prefer a ‘basket’ of individual indices. These baskets tend to break down into four main sub-groups:

  • Energy commodities

  • Agriculturals broken into goods that are grown, such as coffee, sugar, pork and timber, goods that are mined or extracted, such as rubber, and livestock

  • Industrial metals, including copper and nickel

  • Precious metals

Beyond these baskets of commodities you’re into individual indices that track a specific commodity. These indices are the territory of professional investors with specialist knowledge and are best avoided by most private investors.

Although the large variety and range of different index structures can complicate using an index to invest in commodities, here’s my simple guide to the big commodity index providers:

  • S&P Goldman Sachs Commodity Index (GSCI): Perhaps the most widely used index in the US and what’s called a production-weighted benchmark of 24 commodities adjusted for liquidity. It’s currently heavily weighted in energy products with 40 per cent of the index’s weight comprising crude oil futures.

    Agricultural and softs, such as wheat and sugar, make up 11 per cent, metals 6 per cent and livestock 2.86 per cent. Because the GSCI index is based around the notion of ‘world production’, the constituents can vary widely — the dominant energy sector, for instance, has varied over time from 44 per cent through to 78 per cent, making it very volatile indeed.

    This makes the GSCI most susceptible to the effect of rotation between contango and backwardation in crude oil prices.

    This index is best for investors who want more exposure to energy assets, while at the same time (and because of the index’s broad range of commodities), protecting their investment from events that could drag down a single commodity sector.

  • Dow Jones-AIG Commodity Index: An equally popular series of indices that sits at the core of the exchange-traded funds (ETF) securities range of funds. It’s made up of 19 commodities weighted primarily for trading volume and secondarily based on global production, with index rules ‘designed to dampen volatility’ by setting floors and caps on component weights.

    Crucially, the index has been set up so that no single commodity can comprise more than 15 per cent of the index and no single sector can make up more than one-third of the benchmark’s weight.

    By sector, energy carries the biggest weight, at 33 per cent, followed by industrial metals at 20 per cent, precious metals at 10 per cent, softs at 8.7 per cent and grains at 18 per cent.

    This index, like the GSCI, is best for investors who want greater exposure to the energy sector and lower volatility.

  • Deutsche Bank Liquid Commodity Index (DBLCI): Consists of only six commodities, based around the most liquid (in trading terms) commodities in each sector: heating oil, light crude oil, wheat, aluminium, gold and corn. The index company claims that this narrow range of underlying commodities reduces the actual cost of roll and rebalancing.

    In practical terms, it means that energy makes up 55 per cent of the DBLCI; agriculturals and metals equally split the remaining 45 per cent. This index family contains no exposure to livestock or softs.

    Crucially, the designers — and the Powershares range of exchange-traded funds that tracks it — claim a unique ‘roll strategy’: rather than simply rolling expiring contracts to the next available month, the DBLCI looks out as far as 13 months for the contract with the highest roll yield. Theoretically, the index developers claim, this improves roll yields in backwardated and contango-ed markets.

    Because the DBLCI chooses only the most representative commodities in each of the included sectors, it enables investors to buy fewer contracts (6, rather than the 19 or 24 of the other indices, for example) yet still track the index’s performance).

    CRB Commodity Index: Started by the Commodity Research Bureau in 1981, this index comprises 22 futures contracts combined into an ‘All Commodities’ grouping, with two major sub-divisions: raw industrials and foodstuffs. Metals make up 20 per cent, energy carries a weight of 39 per cent and soft commodities 39 per cent.

    This index, because of its reliance on agricultural commodities, has historically tended to produce lower annual returns than the more volatile, and hence, potentially profitable indices that rely on a preponderance of energy commodities. However, as agriculture heats up, this index may be attractive to investors building a more agriculture-centric portfolio.

    Rogers International Commodity Index (RICI): By far and away the broadest and most international of all the indices. Preferred by commodity purists, the RICI consists of 35 commodities, including such exotics as azuki beans, silk, rubber and wool. Energy comprises 44 per cent of the index, agriculturals and softs 32 per cent, metals 21 per cent and livestock 3 per cent.

    A hallmark of this index is its stability (it’s had relatively few changes since its creation in 1998) and it’s best for investors who want exposure to international commodity exchanges.