Direct commodity investment has a place in every investment portfolio.

Commodities are often viewed as defensive asset classes. Not only do they achieve returns that cannot be replicated by combinations of traditional stocks and bonds, but they also prove to be defensive when such a strategy is needed most, e.g., responding favorably to unanticipated inflation while stocks and bonds decline. This observed characteristic stems from the inherent negative or low correlation to traditional asset classes, namely stocks and bonds. However, to be most productive, they should be used in combination with stocks and bonds to take full advantage of their independence from those assets.

The three investable commodity indexes currently available are: the Dow Jones AIG Commodity Index (DJ-AIGCI), Goldman Sachs Commodity Index (GSCI) and Standard and Poor's Commodity Index (SPCI). Each has a particular focus that serves specific needs for different investors. Products based on these indexes are traded over the counter, as well as on exchanges. DJ-AIGCI TRAKRS began trading on the Chicago Mercantile Exchange (CME) on July 1, 2003, DJ-AIG futures were launched on the Chicago Board Of Trade (CBOT) on November 16, 2001, and GSCI futures contracts have been on CME since July 28, 1992. Products based on these indexes are traded by institutional investors. Products like PIMCO Commodity Real Return Fund and Oppenheimer Real Assets Fund, linked to commodity indexes, are also made available to retail investors.

These indexes are comprised of a diverse selection of long futures contracts traded on exchanges. Their returns are a weighted composite of the returns of individual commodities, each of which is influenced by different supply and demand factors and in varied degrees. Each index is sufficiently diversified so that it is only moderately affected by an extreme return, positive or negative, in any one of its constituents.

As illustrated in Table 1, these indexes have different returns over the period January 31, 1993-January 31, 2003 and in the last one, three and five years. Moreover, in any period their returns differ substantially from the S&P 500 and ten-year U.S. Treasury Bonds. In particular, commodities indexes performed remarkably well in the year ended January 31, 2003, a year in which the stock market did poorly.

These indexes also have different volatilities as indicated by their standard deviations since 1993 and the last five years, as shown in Table 2. Their standard deviations also differ from those of stocks and bonds. Interestingly, the DJ-AIG and SPCI have lower standard deviations than stocks over the tested periods, and the GSCI has greater volatility. This further distinguishes the indexes from each other as well as stocks and bonds.

Table 3 dramatically illustrates the generally low correlation between commodities and stocks and bonds over the ten-year period. The correlations of returns vary but, generally speaking, their correlations to stocks and bonds are low and can be negative at times. In particular, over the 10-year period, with a correlation to stocks of less than 0.094 and a slightly higher 0.119 correlation to bonds, one may say this defensive asset class can have strategic importance to a portfolio over the long term. As one might expect, the commodity indexes bear high but not perfect correlations to each other due to differences in their rules of construction and maintenance.

The Sources Of Returns

An equity index has two sources of returns: stock price movements and dividends. A bond index also has two sources of returns: bond price movements and coupon payments. However, a futures-based commodity index has four sources of returns: spot, rolling, collateral and rebalancing.

Spot returns are simply the returns resulting from the underlying commodity price movements.

Rolling returns are achieved by closing one futures contract and taking a position in another futures contract having a later expiration date. This is done to avoid taking delivery of a commodity and to maintain a long position. Returns from the rolling process are possible especially when, close to a contract expiration date, nearby contracts are trading at a higher price or premium to those that are due to expire at a later date, a situation known as "backwardation." Rolling allows capturing returns from possible commodity backwardations as the contract rolls over higher-priced futures contracts into more distant lower-priced contracts.

Collateral returns result from placing margin or full face value of futures contracts with the CME which earns interest, called "T-bill yield." A fully collateralized futures position would be comparable to a long position in stocks or bonds.

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.

Rolling Futures Contracts

Most futures contracts are rolled primarily on a monthly basis, but some are rolled less frequently, namely some grains and precious metals. Liquidity of the underlying commodity determines frequency of rolling. The DJ-AIGCI and GSCI have a five-day roll period close to the beginning of the month. Craig Braswell, manager of index operations at Dow Jones, says, "With a five-day roll period, 20% of the holding will be rolled each day over five days. If all contracts are rolled in just one day, this may result in a big adjustment in the market." The SPCI has a slightly shorter roll period of three days. The DJ-AIGCI and GSCI roll their contracts every month whereas SPCI rolls its contract every two months on average.

Roll returns tend to be negative when a futures price is above the expected future spot price, a situation known as "contango," and positive when the futures price is below the expected future spot price, i.e., when the market is in backwardation. The shorter roll-period results in relatively lower roll costs whereas the longer roll process may have a better chance to capture backwardation.

Index Committee Decision-Making

The construction and maintenance of these indexes are handled by committees to ensure their objectivity and consistency, with each committee being comprised of professionals, academics and exchange representatives. All indexes are re-weighted once a year as determined by their committees to reflect current production and/or liquidity data.

The DJ-AIGCI and GSCI committees make rebalancing and re-weighting decisions in June and November, respectively, but defer implementing them until the following January. The SPCI committee makes its decision in November but defers implementing them until the following February. All three index providers have announced their re-weighting decisions for 2004.

Conclusion

In addition to being a proven effective inflation hedge, there is a definite role for direct commodity investment in every investment portfolio. Additional diversification benefits become more achievable in combination with stocks and bonds. Each index demonstrates different characteristics and strengths. With DJ-AIGCI's maximum ceiling on any single commodity class being 33%, it has more room to include other commodities, making it more appropriate when the investment emphasis is on diversification. The GSCI is more pertinent when the focus is on OECD economic growth with a high concentration in energy. If you are striving to achieve low volatility and benefit from commodity exposure at the same time, SPCI seems to an ideal choice for any investment portfolio. In all, bearing a low to negative correlation to stocks and bonds, commodities, bought through direct investment, prove to be a valuable defensive asset class with strategic importance over the long term.

Pauline Lam is a New York City-based consultant and freelance writer specializing in commodity finance and index research. She can be reached at (212) 829-7189 or [email protected].