Indexing the world's commodities is a complex task and each index accomplishes the objective with differences that have real impact on your portfolio.
Commodities—oil, gold, corn and the like—are often used by investors for their diversification, return-enhancing and inflation-hedging characteristics. Fortunately, there’s now a wide variety of ETPs tailored to make commodity investing easier and more accessible.
One of the most critical questions that must be answered by any commodity index is how to select and weight each commodity in the index to reflect a neutral representation. Equity indices have a similar challenge but can always fall back on market convention to select and weight by market capitalization.
If we’re talking about a broad commodities index though, there is no market convention. Do you include cocoa? What about soybeans? What percentage of the index should oil be?
Of course, there is no market capitalization for corn, so commodities indices must take a different tack than equity indices. One solution is to select and weight commodities based on global production: If 10% of global commodities production is corn, corn should be 10% of the index. The inherent challenge with this strategy is actually counting global production.
Production-weighted indices tend to be very heavy on energy, which is almost always well-measured throughout production. In contrast, rice production, much of which is done on small, local plantations, is harder to account for and thus comprises a disproportionately small portion of the index. Other broad commodities indices tweak the production focus and instead emphasize global consumption.
Still other indices look to the futures market or underlying liquidity to make critical index decisions. There is no right or wrong answer, but considering the state of the futures curve certainly makes sense given that most ETPs use futures contracts to gain their underlying exposure. (For more information on why most commodities ETPs use the futures market to gain their underlying exposure, see “Can You Buy Spot Commodities?”)
We can broadly group today’s commodities indices into three generations. Selection and weighting is an issue relevant to each generation of indices, and approaches can span multiple generations.
The factors that distinguish each generation is its attention to the futures curve and contract selection. That is, once they’ve decided which commodities to include and their relative weights, should they represent that weight with one-month futures contracts, three-month futures contracts or six-month futures contracts? Each provides exposure to the commodity, but each will behave differently and produce different returns.
The first generation of investable commodity indices turns a blind eye to the futures curve. That is, the indices always reflect the performance of the nearest futures contract to expiration, often called the front month, in each commodity that they choose to hold. These indices are easy to understand and implement, and provide the best exposure to “spot”, but they were not designed to maximize returns, as holding one-month contracts is suboptimal in many situations.
The second generation of investable commodity indices acknowledges the effects that contango and backwardation have on returns. Once the constituents and relative weights have been decided, these indices select contracts for each commodity with the intent to minimize contango. If the six-month corn contract exhibits less contango than the three-month contract, these indices will specify the six-month contract.
The third generation of commodities indices takes the second-generation approach one step further. These indices will sell futures contracts on commodities exhibiting the steepest contango and buy contracts on commodities exhibiting the deepest backwardation.
In terms of returns, each of these three approaches has successively improved on the theoretical performance profile of their predecessors. However, it’s impossible to conclude which approach will produce the best returns moving forward. Sometimes the front-month funds will outperform, sometimes the newfangled third-generation indices will.
Ultimately, commodity indices must make a range of decisions, from selecting and weighting their constituents to selecting contracts for each commodity. Unlike in equities, there isn’t a standard market convention for commodities which makes attention to index methodology all the more salient for investors. Historical results show that the old-fashioned front-month products are best at tracking short-term spot movements. However, newer products have had some success in minimizing volatility and maximizing returns from commodity markets and are worthy of consideration.