The Universe of
Commodity Indices
This article is divided into three broad sections. The first outlines the universe of commodity indices
and the characteristics that differentiate them apart. The second and third sections examine the
sources of returns as well as the benefits of commodity index investing.
By Michael Lewis
BEFORE 2003, the universe of investible my, it is not financially traded due to the numerous grades available
commodity indices was limited to just and consequently the difficulties in establishing a widely recognised
the Goldman Sachs Commodity Index, benchmark. Instead steel prices are determined by individual con-
the Dow Jones-AIGCI and the Rogers tracts between producers and consumers which prohibits steel, for the
International Commodity Index. time being, from being included in a commodity index.
Since then the population of Rice is the staple diet for half of the world’s population and is
investible commodity indices has grown in every continent except Antarctica. China and India account
exploded and index performance has for half of the world’s production and all Asia combined constitutes
become highly divergent. As a result, 90% of global rice production. The CME Group, the AFE in Thailand
investors need to be acutely aware of and the NCDEX and MCX in India are the only exchanges in the
the characteristics that differentiate world listing rice futures. Like steel, rice grades are variable and the
the numerous commodity index prod- liquidity of rice future contracts has so far been negligible. On
ucts in the marketplace. NYBOT, turnover of the rough rice contract in 2006 was just 320K
lots (Figure 1).
Section I: Overview Despite the potential difficulties in constructing a representative
The construction of a commodity commodity index, this has not deterred the rapid development of
index has employed the minds of many the commodity index space during this decade. The major determin-
academics and investment bankers ing features of a commodity index are:
over the past few years. However, no 1) How many commodities are included and in what proportion?
commodity index can be truly represen- 2) What is the selection process for the inclusion and what are the
tative of the entire commodity complex criteria for the re-weighting of the commodity basket?
since none of them include the two 3) Which specific futures contracts are used for each commodity?
most important commodities in the 4) How are these futures contracts rolled?
world: Steel and Rice. 5) Are the commodities reset to base weights periodically?
World crude steel production reached
1.22 bn tonnes in 2006. This compares Number of Components & Weights
with aluminium production, which The number of commodities within an index varies from as low
exceeds the combined production of all as six for the Deutsche Bank commodity indices to as high 45 and
the other non-ferrous metals, of just 34 36 for the Diapason Commodity Index and the Rogers
Mt over the same period. Despite the International Commodity Index respectively. The factors deter-
importance of steel to the world econo- mining the individual component weights are typically a function
of world production and consumption, global inventory levels,
Figure 1: Comparison of Futures Turnover, 2006
open interest and market turnover. In certain commodity indices,
weights for individual commodities or sectors are capped. For
Annual futures turnover in various agricultural
products on US exchanges (million lots)
example, the DBLCI-Optimum Yield Balanced caps the weight of
any one commodity or closely correlated commodities to 35% in
order to be UCITS III compliant.
The Dow Jones-AIGCI prohibits any single commodity constitut-
ing less than 2% or more than 15% of the index and any individ-
ual commodity sector weight exceeding 33%. For the majority of
commodity indices, rebalancing is undertaken once a year and can
occur on a discretionary basis via an investment committee such
as the procedures adopted by the Dow Jones-AIGCI, the S&P GSCI
and the Rogers International Commodity Index (RICI). For others,
Sources: CBOT, NYBOT
re-weighting can occur mechanistically or not at all, for example
for the DBLCI-Mean Reversion.
40 SEPTEMBER 2007 COMMODITIES NOW
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