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December 4, 2011 4:59 pm
The arguments in favour of using indices as a means of investing in commodities are well rehearsed. At the top of most lists sits the avoidance of physical delivery, which could be awkward in terms of logistics and expensive in terms of storage.
The most popular indices are Standard & Poor’s GSCI (S&P GSCI), the Dow Jones-UBS Commodity Index (DJ-UBS) and the Rogers International Commodity Index (RICI).
S&P GSCI started life in 1991 as a joint effort between Standard & Poor’s and Goldman Sachs. It is described as the first truly investable index of its kind, and the largest, with an estimated $100bn-plus of investment tied to it. It features 24 commodities, and offers the least diversified investment exposure of the big three. It is heavily weighted towards energy, mostly oil.
The DJ-UBS Commodity index includes 19 commodities with specific minimum and maximum weightings; a commodity should have at least a 2 per cent weighting and (together with its derivatives) a maximum allocation of 25 per cent, while no related group of commodities (e.g., energy, precious metals, livestock or grains) should constitute more than a third of the index.
The volume of assets under management (AUM) has almost doubled in two years as asset allocation to commodities has grown. It stands at $80.2bn at the end of the second quarter, says Jamie Farmer, executive director of Dow Jones Indexes.
The RICI started in 1998. Today it contains 38 commodities quoted in five different currencies, listed on 13 exchanges in six countries. Weightings can be as low as 10 basis points for greasy wool (a basis point is one-100th of a percentage point), an allocation that even its fondest admirers would surely dismiss as an economic irrelevance.
The index has remained virtually unchanged since its inception, says its creator, Jim Rogers. “Other indices change dramatically every year or so,” he says. “To me, that’s not index investing, which should be passive; that’s active investing, which may partly explain why my index outperforms the others.”
Iwan Brauer, client portfolio manager at ING Asset Management, explains some of the underlying thinking behind the composition of the different indices. “The weighting criteria are different. S&P GSCI primarily looks at world production, and the large production of oil makes it the biggest commodity in the index,” he says.
“DJ-UBS looks at the world’s production of commodities and the volumes of financial instruments traded on those commodities.” The RICI Committee of “wise men” bases its selection on world consumption patterns and liquidity.
For investors seeking a spread across sectors, DJ-UBS is arguably best, says Dan Peirce, a portfolio manager at State Street Global Advisors. Rebalancing, as with S&P GSCI, takes place annually.
The differences in composition are reflected in returns. Figures from Mr Rogers show respective compound annual returns since August 1998 as 5.89 per cent for S&P GSCI, 6.62 per cent for DJ-UBS and 10.46 per cent for RICI. Volatility deviates, too, reaching 24.69 per cent annually in S&P GSCI, 17.71 per cent in DJ-UBS and 19.90 per cent in RICI.
Families of sub-indices are emerging to meet the needs of investors who want a different bias than the parent index offers, by slicing and dicing sector exposure and asset allocations. Other changes can be made to reflect concerns about the yield-dragging phenomenon of contango, which prevails when forward contract prices trade higher than spot prices.
Opinions about contango are mixed. On the one hand, it is accepted as an inherent element of the commodities landscape. “You can’t make contango go away when it’s part of the marketplace,” says Mr Peirce.
On the other hand, indices can take steps to reduce contango’s impact, says Eleanor de Freitas, BlackRock’s head of index for the Emea region: “The tweaking of indices so that they focus on the two- or three-month forward contract rather than the traditional one-month will deliver a different return profile.”
Investors could always, though, take an alternative approach, says Dimitris Melas, global head of new product research at MSCI. “We have built equity indices to track sectors related to commodities, offering exposure to producers in energy, metals and agriculture.” For investors struggling to come to direct terms with contango and backwardation, a proxy such as this might prove to be more attractive than the real thing.
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