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Not All Commodity Indexes Are Created Equal (Part One of a Two Part Series)

By: Richard Feldman

By: Richard Feldman, CFP, MBA, AIF

Direct investment in commodities has become far easier with the advent of a series of funds based on popular commodity indexes but performance can be drastically different due to the composition and methodology of index construction. The most widely followed commodity indexes are the Goldman Sachs Commodity Index (GSCI), Dow Jones AIG Index (DJAIG), Reuters-CRB Index, The Rodgers International Commodities Index, and the Standard & Poor’s Commodity Index. But, you must choose your index carefully. “The huge discrepancies in component weightings between indexes can cause them to perform quite differently, in the first three month of this year alone, the performance varies from 10.55% (CRB) to 21.98% (GSCI); over the past seven years, the compounded annual return runs from 5.33% (CRB) to 18.83% (RICI).[1] This article will explore the characteristics of each index and the methodology used to create each index so that you can an informed decision when incorporating commodities into your investment portfolio.

Reuters-CRB Index

The CRB index is the most widely known and followed commodities index. Typically when the financial press and media are talking about rising commodity prices they’re usually talking about a rise in the CRB index. The CRB index tracks 17 different commodities and weights each commodity equally at 5.88% of the index. “The CRB is a widely followed index, but its methodology raises obvious problems for a commodities investor: Can the price of orange juice be as important as the price of Oil?”[2] The answer to that question is a resounding no, especially in today’s environment.

Because of this structural flaw the CRB index is going through some change. Thanks to a new partnership with the investment bank Jeffries Group, the CRB index is getting an overhaul. Looking for an opportunity to build its brand in the commodities space, Jeffries has joined forces with Reuters to revise the CRB Index.

The CRB index is adding three commodities (Aluminum, unleaded gasoline, and nickel) and deleting platinum. In addition the index is being reconstituted from a equally weighted index to hybrid methodology that attempts to balance diversification and the economic relevance of each commodity in the index. The biggest change comes in the weight of crude oil which jumps from 5.88% to 23%.

Goldman Sachs Commodity Index (GSCI)

The GSCI was created in 1992 to provide a better representation of worldwide commodity consumption and to correct the problems associated with the equal weighting of the CRB Index. The GSCI is made up of 24 commodity components. The goal of the GSCI was to measure commodities in a way that reflected their importance to the global economy. “Basically, components of the index are weighted based on the average dollar value of their production over the trailing five year period. For instance, if the world produced $10 dollars of wheat a year and $1 of corn, wheat would have 10 times the weight of corn in the index. Production weighting is an intuitive approach to weighting commodities: The more of something we use, the more important it is to the economy.”[3]

The GSCI also has many vocal detractors of the index. In today’s current environment energy dominates this index to the tune of nearly 75%. The main complaint is that the components that make up the other 25% of the GSCI have very little overall effect on the total return of the index.

GSCI has produced significant returns over the past three years due to it’s heafty weighting of the energy components such as: crude oil, brent crude oil, natural gas, unleaded gas, heating oil, and gas oil.

The Standard and Poor’s Commodity Index

“The SPCI focuses on the “investabality” of different commodities to determine their weight in the index. Specifically, S&P relies on open interest in commodity’s futures contract to determine its weight. If oil futures trade 10 contracts a day and natural gas futures trade one contract a day, oil would receive ten times the weight of natural gas in the index.

The argument behind the methodology based on open interest is that interest in the futures markets reflects the financial importance of a commodity on a global basis. In basic terms the more important a commodity is to the global market place the more producers and traders will want to buy, sell, or hedge their exposure in the open market place.

“Not surprisingly, the S&P’s methodology leads to some odd weighting comparisons in the index. For instance natural gas is assigned twice the weight (17.6%) of crude oil. But few would argue that natural gas is twice as important as crude oil to our economy.[4]

In addition Standard & Poor’s has excluded gold as one of its components arguing that it is a financial commodity and not an industrial commodity.”

Dow Jones AIG Commodity Index

The DJAIG index adopts a hybrid methodology combining liquidity factors such as open interest in futures contracts and production weighting. The DJAIG index also places a limit of 33% on any one sector of the commodities index. This has limited energy to less than 33% which filters greater percentages to other sectors of the index such as industrial metals, grains, precious metals, and softs.

The Rogers International Commodities Index

This index is named after Jim Rodgers a former partner of George Soros. Jim Rodgers has created the most diversified commodities index available currently tracking 35 commodities which is 11 more than its closest competitor the GSCI. The index was created in 1999 because Rodgers was frustrated by the shortcomings of the other available indexes in the commodities space. The index was structured by a panel of experts who weight each commodities importance to the global economy.

The index includes commodities that do not appear in any other index such as: rice, rubber, and lumber. Liquidity in the above commodities is extremely limited due to the fact that not many futures contracts trade in these commodities.

Summary

Investing a portion of your assets in commodities is a great way to increase the diversification of a portfolio. Understanding how commodity indexes are constructed and the differences between component weightings of a particular index is integral to selecting a particular investment vehicle. The incremental demand for commodity investment vehicles will surely lead to better indexing options and methodology in the future as indexes are revised and improved upon.

In our next issue, I will analyze how the inclusion of commodities in a portfolio, can lead to an increase in portfolio returns on a risk adjusted basis.

[1] Choose Your Commodity Index Wisely, Hougan, Matthew, Index Fund Universe

[2] The CRB Gets Real, Index Universe Staff, Index Fund Universe

[3] Choose Your Commodity Index Wisely, Hougan, Matthew, Index Fund Universe

[4] Ibid.