Which Commodity Index is right for You?
Why choose a commodity index?
One index will give more emphasis to a particular commodity class than another index.
You may prefer one method of measurement to another. Here we look at the main commodity indices and how they compile their benchmarks for these natural resources markets. Goldman Sachs
The Goldman Sachs (S&PGSCI) Commodity Index makes available to investors a benchmark for investment in commodity markets by referring to either the S&P 500 or FT share indices.
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The S&P GSCI is made up of commodity sector returns and index weightings are based on average world production levels. This way it reflects economic activity over the previous 5 year period and signals investment performance. An important feature of the index is that each component commodity needs to satisfy liquidity requirements.
And given that the focus is on production levels, the GSCI will be weighted towards energy-related commodities such as oil and natural gas.
This index currently has 5 industrial metals, including aluminium and copper, 8 agricultural commodities including wheat and soybeans, 3 livestock sectors including lean hogs, and 6 energy products including crude oil, the largest component. The broad spread across the commodity universe aims to reduce volatility that may arise due to a significant event within one of the constituent sectors. As an example, on 4 March 2008 the GSCI was made up as energy (71.16%), industrial metals (8.27%), precious metals (2.29%), agriculture (15.18%) and livestock (3.09%). The largest sub-sector component was crude oil at 37.22%. Some commentators believe this method of compiling a commodity index leads to a disproportionate weighting to energy, with a whopping 71%. So that if there was a significant fall in the price of crude oil, the index would be affected proportionately. Could this affect the decision of potential investors looking to diversify into commodities?
Rogers International The Rogers International Commodity Index (RICI) is a US dollar denominated, composite index set up by Jim Rogers in 1998. It consists of a broad basket of 35 commodities in the world economy, designed to represent the changes in raw material prices worldwide. A commodity is selected for the RICI on the basis of whether it makes an impact on global consumption. The largest component is crude oil (traded on NYMEX and ICE), representing about 35% of the index. Wheat (7%) represents the largest agricultural product component, with aluminium (4%) and copper (4%) leading the industrial metals. All the components are US dollar denominated except for Azuki beans and rubber (Japanese Yen), greasy wool (Australian dollar) and barley and canola (Canadian dollar). The RICI aims to provide a steady, consistent means of investing across a diversified spread of world commodities. Futures contracts are used to achieve exposure in four currencies (mainly US dollar) and on commodities traded on eleven recognised exchanges. Each year the RICI committee reviews both the selection and weighting of index constituents. If the balance is changed it is usually to address stability and liquidity of a particular commodity sector.
Investors could consider the Dow Jones AIG Commodity Index (DJ-AIGCI) for monitoring the markets or possibly as a vehicle for exposure to commodities. It is made up of futures contracts covering 19 commodities, and is a rolling index because near-expiry futures are sold as a new contract with a longer delivery date is purchased. This process is called a rolling futures position which ensures the index continues to hold a long futures position. Unlike, for example, the Rogers International Commodities Index, the DJ-AIGCI only reflects commodities traded on US exchanges; with the exception of the base metals nickel, aluminium and zinc which are traded on the London Metal Exchange(LME). Component weightings of the DJ-AIGCI are worked out on the basis of the relative trading activity of the commodities within the index. Other factors given due weighting are market liquidity levels of the futures representing a given commodity and production data, both averaged over a 5 year period. No single sector is given undue weighting which helps avoid unwanted volatility arising from unusual or unpredicted events such as a crop failure or a flooded mine. One method of achieving this stability is by ensuring no single commodity makes up more than 15% or less than 2% of the index. Every year the DJ-AIGCI Advisory Committee meets to work out the make up of the index for the next 12 months. As an example, the target weightings from January 2008 were agreed upon in August 2007. In 2008, petroleum is the largest component at 20.76%, with natural gas at 12.24%, making overall energy the most significant group contributor at 33%.
If you thought that the above three indices would possibly be enough to give you a picture of commodity markets, then you would be mistaken. There is also the Reuters/Jeffries CRB Index, formed in 1957 and made up of a basket of 28 commodities. This commodity index has been revised on 10 occasions and aims to provide a benchmark reflecting liquidity and relevance to the global economy of the individual constituents. While previously each component was equally weighted, since the 2005 revision the Reuters/Jeffries CRB Index now uses a tiered structure for weighting purposes. There are four groups, with Group 1 made up of hydrocarbons, namely West Texas Intermediate(WTI), Heating Oil and unleaded gasoline (petrol). Group 1 makes up one third of the index, reflecting how important the prices of these energy commodities are to global economic growth. The second group are considered highly liquid and each of the seven constituents are equally weighted at 6%. There is exposure to agriculture (corn, soybeans) as well as precious (gold) and base (copper) metals. Group 3 includes foods, cocoa, coffee and sugar and at 5% each, provide further diversification. Each constituent of the fourth group is given % weighting, and they provide more diversification, including nickel, orange juice and silver. It is possible to invest in funds which replicate some of the above indices such as ETF's, and this may be an approach you take rather than directly trading futures contracts. As new materials are discovered and environmental challenges come along, we can expect to see ongoing changes in how a commodity index reflects the natural resources universe.
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