There are essentially two ways for investors to gain broad exposure to changes in commodity prices. First, there are several long-only commodity indices that give investors exposure to passive long positions in a number of commodity futures contracts. This allows them to participate in gains that would otherwise only be earned from holding individual positions in these contracts. An investment in a commodity index does not give the investor ownership of the cash commodity, but rather, an exposure to changes in the future expected price,7 thus allowing an investor exposure to a broad section of the commodities market.
The second way for investors to gain broad exposure to commodities is through managed futures products that take both long and short positions in various commodities using different trading strategies. There are advantages and disadvantages to each type of product. We will first look at long-only commodity indices, how they are constructed, and how an investor might utilize these products to invest in this asset class.
LONG-ONLY COMMODITY INDICES
Just as stock index funds seek to replicate a portion of the equities market, long-only commodity indices give an investor exposure, typically through futures contracts, to a crosssection of the commodities market. As with equity indices, that have specific weights in individual securities, commodity indices have weights to certain areas of the commodity market, such as energy, grains, metals, or livestock.
Commodity Incdices and their Construction
Commodity indices can be constructed using several different methodologies, all of which will impact the returns and the underlying volatility of the index. The three primary methodologies include production weighting, optimized weighting, or equal weighting.
Production weighting involves assigning weights based on a moving average of world production.A production-weighted index will also have a heavier weighting in sectors that may be more important in the economy such as oil and natural gas. As a result, these allocations will have a disproportionate impact on the performance of the index.
An optimized-weighted index includes specific constraints and objectives such as correlation with inflation, negative correlation to equities and fixed income, a focus on liquidity, and the sectors that are most relevant.
Finally, an equal-weighted index keeps price fluctuations in any one sector from disproportionately impacting the index, but does not over/underweight sectors that may be more important in the economy, such as oil and natural gas, which are key elements in most industrial economies.
The second way for investors to gain broad exposure to commodities is through managed futures products that take both long and short positions in various commodities using different trading strategies. There are advantages and disadvantages to each type of product. We will first look at long-only commodity indices, how they are constructed, and how an investor might utilize these products to invest in this asset class.
LONG-ONLY COMMODITY INDICES
Just as stock index funds seek to replicate a portion of the equities market, long-only commodity indices give an investor exposure, typically through futures contracts, to a crosssection of the commodities market. As with equity indices, that have specific weights in individual securities, commodity indices have weights to certain areas of the commodity market, such as energy, grains, metals, or livestock.
Commodity Incdices and their Construction
Commodity indices can be constructed using several different methodologies, all of which will impact the returns and the underlying volatility of the index. The three primary methodologies include production weighting, optimized weighting, or equal weighting.
Production weighting involves assigning weights based on a moving average of world production.A production-weighted index will also have a heavier weighting in sectors that may be more important in the economy such as oil and natural gas. As a result, these allocations will have a disproportionate impact on the performance of the index.
An optimized-weighted index includes specific constraints and objectives such as correlation with inflation, negative correlation to equities and fixed income, a focus on liquidity, and the sectors that are most relevant.
Finally, an equal-weighted index keeps price fluctuations in any one sector from disproportionately impacting the index, but does not over/underweight sectors that may be more important in the economy, such as oil and natural gas, which are key elements in most industrial economies.
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