A Review Of Commodity Indexes

April 01, 2004

    Illustration By Greg Hargreaves

INTRODUCTION

In his research paper 1, Barry Bannister presents eloquent and convincing arguments to support the notion that inflation and commodity prices will increase substantially over the next several years.

One of his arguments is that "for 200 years, paper assets have alternated price leadership with hard assets, corresponding to falling and rising inflation cycles" lasting about 20 years each. See Table 1 for a comparison of the growth rates of the stock market and commodity prices since 1898.
Chart A 2 shows not only the clear cyclical trend of stock returns minus inflation, but also the possible start of a new trend in which stock prices could stagnate and inflation rise. Application of this possibility to Table 1 suggests an impending period of commodity price increases leading stock price increases, with occasional reversals within the trend.

Another argument relates to demand for commodities from the faster-than-historical industrial and consumption growth in large emerging economies such as China, India, and others. Taking energy as an example, Chart B shows the per capita oil consumption during the industrialization phase of the U.S., Japan and South Korea. It also shows that increasing China's per capita consumption to the levels reached by Japan and South Korea would require an enormous increase in worldwide production. Unless this increase materializes immediately, energy prices can be expected to increase dramatically.

INVESTIBILITY

Given that there is a fair argument for an increase in commodity prices over the next several years, should investors take an exposure to commodities? If so, which commodities and in what proportions?

This article discusses five commodity indexes, which can be used as the basis for acquiring exposure to commodities. They are somewhat different from one another in the commodities they comprise and their relative weights. An investor can choose one of these indexes, and replicate it by adhering to the related Rule Book. As an alternative, an investor can invest in a fund that replicates the chosen index. In addition some firms, including InvestMatrix, are developing exchange-traded funds (ETFs) based on commodity indexes.When available, these ETFs could be convenient vehicles for investments in commodities.

But before delving into the index methodology of commodities benchmarks, it is first necessary to understand certain peculiarities of this distinct asset class.

Comparison To Equity And Fixed income

Similarities and differences between this asset class and equity and fixed-income securities are worth noting. Equity and fixed-income securities can be easily purchased, and while equity securities may yield an income in the form of dividends the primary objective is capital gains. With fixed-income securities, the primary objective generally is income (interest) and capital gains are secondary. By holding physical commodities, the investor looks entirely for capital gains, and expects no income at all (except for pos sible asset-lending income in rare cases, which can be i g n o red for the purposes of this discussion).

An important distinction with commodities as an asset class is storage, including transportation, insurance, warehousing and incidentals. Whereas equity and fixed -income securities can be easily stored as bits of paper or electronic entries after purchase, storage of physical commodities involves complications; for example, consider storing crude oil and wheat as part of one's investment.

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