As investing interest in natural resources increases, more market users watch commodity futures to monitor activity. One way to get a broad exposure to commodities is to use indexes, which can package several commodity markets into one vehicle.
There are several commodity indexes available for investors’ use. One of the most popular is the Dow Jones-UBS Commodity Index. This index is comprised of a basket of futures contracts representing energy, metals and agriculture markets, so it gives a wide measure of the overall market.
Daniel Raab, managing director, head of commodity investor marketing and structuring at UBS, says that generally, indexes use a predetermined methodology to create diverse exposure. Some indexes use a commodity’s production, others use a contract’s market liquidity and other index creators select certain commodities and assign them equal weighting. Dow Jones and UBS use world production and market liquidity to determine the target weightings for their index.
“We blend them together, using one-third production and two-thirds liquidity,” Raab explains. “In addition the DJ-UBS has group limits, so no group, such as petroleum, is over 33 percent, no individual commodity is over 15 percent and no commodity is under two percent as of the annual reweighting.”
Most investors are familiar with the concept of an index because of the popularity of stock market indexes like the S&P 500. Commodity indexes are similar, but the biggest difference is that commodity indexes are based on futures contracts that periodically expire, rather than stocks which have no expiration date.
Because futures contracts expire, those positions must be rolled forward from the first contract month to what will be the next included month, prior to first notice day, to avoid delivery.
In addition to the monthly roll, commodity indexes are often rebalanced annually or semiannually to compensate for the changes in value each commodity experienced and changes in weighting parameters like world production and liquidity. Raab says the rebalancing brings each market back to its target weight.
The new weightings are announced a few months ahead of the actual change so firms tracking the index will have ample time to prepare. The DJ-UBS rebalancing occurs in January, with positions rolled on the fifth through ninth business days of the month. “The idea is to spread it out to give a reasonable window to complete the change,” Raab says.
Using Commodity Indexes in Portfolios
Jack Hansen, CFA and chief investment officer, and Jeffrey Rodgers, CFA and portfolio manager of The Clifton Group, use commodity indexes in a variety of ways to help their clients gain exposure to the commodities markets.
Some clients simply want a commodities exposure to diversify their portfolios from a risk management perspective and are content to use an index to get a passive exposure to the market, while some are more active, they say. Using an index to add commodities to a portfolio is a low-turnover strategy that reduces costs.
“That’s where a passive index strategy has an appeal – you can have a higher return than active trading simply through lower fees,” says Hansen. “Indexes are a popular way to start as a new investor.”
Indexes are also very liquid instruments, meaning institutions can take positions without fear of roiling the market. The DJ-UBS index and its predecessor have been around since 1998 and as of the end of 2011, had $74.2 billion tracking the family of indexes. Since July 31, 1998, to May 31, 2012, the annualized return of the DJ-UBS Total Return Commodity Index, which includes the implied T-bill return, is 5.17 percent, Raab says.
Rodgers notes a broad index allows more passive investors to get exposure to markets that may suddenly turn volatile without having to chase relative performance. “Rebalancing is a good way to add value over the long run,” he says. “As good as managers are, they’re not always going to pick the right market all the time.”
For more active strategies, the roll period and rebalancing offer a chance to outperform the index, says Rodgers. Since these activities are built into the structure of the index, trading in anticipation of the monthly roll or the rebalancing period can add value. Rodgers explains that trading outside the index roll period performs better versus putting on the same trade during the roll period.
“So many indexes follow the same schedule that it’s an important phenomenon,” Rodgers says. “We add value by staying outside that window. It’s like when S&P announces a new stock is added to the index. If it’s a smaller company, you can see the stock price jump because people know the Vanguards, the Fidelities and the Northern Trusts have to come in and buy.”