Rebalancing returns result from reallocating positions out of the commodities in an index that have appreciated into those that have underperformed. To the extent that commodity markets exhibit mean-reverting characteristics over time, this approach may result in higher returns. If rebalancing takes place on a daily basis, the strategy will involve selling into an uptrend and buying into a downtrend. It never allows profits or losses to run, contributing to their lower volatility.
The Benefits Of Diversification
Energy, agricultural, livestock, industrial metals and precious metals all have distinct supply and demand fundamentals. They are influenced by everything from temperature levels and snowfall to inflation expectations, but they impact the sectors in very different ways. The main purpose of diversity in a commodity index is to minimize the effects of highly idiosyncratic events, which have large implications for the individual commodity markets but are muted when aggregated to the level of a commodity index. As a result of different construction rules formulated by different index providers, each index has a diversified mix of commodities, and it manages to emphasize the economic or commercial importance supported by particular commodity sectors. Mark Tolette, vice president of Goldman Sachs Futures, says, "Power will also be included in the index, if there are contracts traded on exchanges because of its economic importance."
An Important Distinction
A distinction needs to be drawn between direct investment in commodities and an equity investment in commodity production companies or natural resources mutual funds. The latter does not yield the same level of returns as derived from the former. The main reason is that companies tend to use risk management techniques to mitigate the commodity price risk that drives the commodity returns. Hence, there is very little impact on the firm's equity position as a result of short-term commodity price changes. They are primarily influenced, however, by structural and long-term changes in commodity prices.
Weighting Methods Used In Indexes
In determining how much of each commodity can be included in the index, the weighting strategies vary from one provider to another. As illustrated in Table 4, the method for calculating the commodity weights is different for each index. GSCI is production-weighted; the weights are determined by the five-year average of the world production data published by the Organization for Economic Cooperation and Development ("OECD"). This index's underlying objective is to reflect the economic importance of the specific commodity classes.
Unlike the GSCI, the SPCI places full emphasis on the commercial importance of its commodities by including the "commercial" portion of the open interest for the last two years, as identified in the Commission Futures Trading Commission (CFTC) and excluding all speculative transactions. The inclusion of the commercial portion exhibits a high degree of liquidity. On that basis, the index appears to be more investable. The exclusion of a speculative portion eliminates the volatility brought by price spikes and sharp falls. Institutions would tend to avoid investments in speculative trades as they lessen predictability of the expected returns.
The use of production weights may not reflect the market's perception over time regarding the investment value of storable commodities, such as gold. To counteract this, the DJ-AIGCI is one-third production-weighted and two-thirds liquidity-weighted, using five-year average production and liquidity data to construct and maintain its index. The DJ-AIGCI goes one step further by placing additional constraints on the weighting scheme in order to create a more diversified composite index. No single commodity sector can go above a one-third weighting or below 2%. In sharp contrast to this approach, the GSCI appears over-weighted with 64% in the energy sector, reflecting its importance in the OECD world production data.
Commodity Weights Used In Indexes
As expected, the major commodity indexes contain many common elements, but in different proportions. The GSCI contains the greatest variety with 25 commodities in five sectors; energy is its largest sector (64.5%), agriculture (18.0%), industrial metals (7.0%), livestock (8.2%), and precious metals (2.4%). The DJ-AIGCI has the next greatest number with 20 commodities, also in six sectors: energy is also its largest (30%), grains (20%), industrial metals (19%), livestock (10%), precious metals (9%), agricultural (10%), and vegetable oil (2%). The SPCI with the lowest number of commodities, 17, has them spread across six sectors; its largest in energy (50.5%), fibers (3.7%), grains (21.2%), meats (7.8%), metals (6.8%) and agricultural (10.5%).
Liquidity
In order to emphasize liquidity and avoid double-counting, the SPCI discounts the upstream commodities by a fraction before including it in the index when it repeatedly appears in related downstream commodities. With a more market-driven mentality, gold is considered non-consumable, hence, is excluded from the SPCI but included in the GSCI and DJ-AIGCI. The DJ-AIGCI holds the largest portion of gold, holding the view that gold is heavily influenced by global monetary stability and liquidity.
The liquidity of commodities derivatives markets is at its maximum when the underlying commodity markets are open. Hence the SPCI endeavors to match the trading hours of the derivative markets with the opening of underlying commodity exchanges. For this reason, the SPCI includes only U.S. exchange-traded commodities to maximize the liquidity in related derivative trading. The GSCI has two energy contracts traded on the International Petroleum Exchange (IPE) and five metal contracts on the London Mercantile Exchange (LME). Despite the timing difference in market openings, derivative trading liquidity is not much affected given that energy contracts comprise a large part of the index, and are traded in New York Mercantile Exchange (NYMEX). The DJ-AIGCI has three metal contracts traded on the LME.
Return Calculations
The method used for calculating returns will affect a commodity's weighting in an index. As evidenced in Table 5, the major indexes use different methods for calculating returns. For example, the SPCI uses a geometric return calculation whereas the GSCI and DJ-AIGCI both use an arithmetic return calculation. With an arithmetic return calculation, the annual pre-determined dollar-weighting changes as soon as the underlying commodity prices change. According to Thomas Glanfield, GSCI Analyst at Goldman Sachs, "The adoption of an arithmetic calculation is a market convention and it facilitates the comparison with other financial indexes." With a geometric return calculation, a change in commodity prices has no impact on the pre-determined dollar-weighting. The weighting of each commodity will remain constant until the next re-weighting takes place. The SPCI adopts the geometric calculation which allows the greatest stability and transparency in its weightings. Investors thereby know with certainty their commodity exposure.