Eminent International Indices-Commodities

The following is a brief summary of several long-only commodity index products that are available to investors seeking broad exposure to the commodity markets.

Commodities Research Bureau (CRB) Index: The CRB Index began trading on New York Futures exchange in 1986 and is the oldest of the indices. While futures on the index began trading in 1986, it was first calculated by the CRB in 1957 and has data going back to 1958. The index includes 17 individual components, which are equally weighted. This is one of the key drawbacks to the index because a product like corn or wheat will have the same weighting in the index as crude oil, when oil has significantly more economic impact than corn.

Goldman Sachs Commodity Index (GSCI): The GSCI index was created in 1992 and is available in the form of a single futures contract on the Chicago Mercantile Exchange. While it was launched in 1992, the GSCI has back-tested data going back to 1970. The index consists of 24 individual components and weights are assigned based on a five-year moving average of world production values. The result is that the index has a heavier weighting in commodities with more economic importance and higher liquidity. Consequently, the GSCI has a weighting of nearly 70% in energy related commodities making its performance highly sensitive to the energy markets and fluctuations in energy prices. The GSCI is rebalanced annually, and utilizes an arithmetic average in constructing returns for the index. Given its liquidity and longer performance data, the GSCI is often used as a proxy to analyze commodity returns.

Rogers International Commodity Index (RICI): Jim Rogers, a private investor and former hedge fund manager, created the RICI in 1998. Its weightings are based on world consumption patterns of raw materials and their relative importance in international commerce according to the research of Jim Rogers. The RICI is the broadest and most comprehensive index, consisting of 35 different commodities. Some of these components are less liquid and include obscure commodities such as flaxseed, azuki beans, canola oil, and raw silk. Weights for the individual components are fixed and the index is rebalanced monthly. The RICI is only available through a limited partnership and while it offers the broadest exposure of the major commodity indices, there could be some risk related to the liquidity of some of the index components.

Dow Jones AIG (DJ-AIG) Index: The DJ-AIG was established in 1999 and relies primarily on liquidity data and, to a lesser extent, dollar-adjusted production data in determining the relative weights of commodities in the index. All data used in both the liquidity and production calculations are averaged over a five-year period to determine component weights.11 The index holds 20 components and limits any related group of commodities to 33% in order to ensure diversified exposure to commodities. Like the GSCI, the DJ-AIG index is rebalanced annually. The reason for using liquidity data rather than production data is that liquidity is an important indicator of the value placed on a commodity by financial and physical market participants. Production data alone can underestimate the investment value that financial market participants place on certain commodities.

Commodities Investing-III::Participants & Exposure

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.

Commodities Investing-II::Participants

There are two groups of participants in the futures markets.

The first group of participants comprises buyers and sellers of goods, known as commercial participants, or hedgers. This group includes farmers and other producers of goods who wish to sell their products at a specified price as well as buyers of commodities who wish to hedge against price increases.Commercial participants are not in the futures markets to make a profit, but rather to protect themselves against price changes. For example, if the price of corn drops before the time the farmer sells his futures contract, he is still guaranteed the price at which he sold the contract.

The second group of participants in the futures market is investors (also known as speculators). Investors serve an important function in the futures market because there is often an imbalance between those wanting to sell contracts and those wanting to buy. Investors provide much needed liquidity to the futures markets and are compensated for taking on this role.

One of the distinguishing factors regarding the futures markets is that they exist primarily to protect against price uncertainty for buyers and sellers of goods. As a result, most of the participants are not in the market to make a profit, but
rather to hedge against price risk. This can sometimes create opportunities for investors (or speculators) to make a profit.

Commodities different and Paper Assets!!
Commodities differ from paper assets (equity and fixed income) in that they require storage costs. While paper assets can be held in brokerage accounts at little or no cost, commodities such as crude oil, wheat, or livestock obviously cannot be stored in a vault or electronically in a database and storage costs for commodities can sometimes be significant. Storage costs must be a consideration for an investor, as they will impact the pricing structure of futures contracts of individual commodities. For this reason, the change in the price of futures contract for a commodity may vary from the change in the price of the underlying commodity because futures contracts take into account these storage costs. As a result of storage costs, longer dated futures contracts (for example, delivery in six months), will generally be priced higher than shorter dated futures contracts for delivery in one month.