Riding The Wave

September 01, 2005

Rebalance Rules

The timing of index rebalances can also impact performance. An index may experience a period of rapid price appreciation in a specific sector, but in many cases, the index rebalance period may not occur until after the underlying prices have given back the gains.

Weighting Rules

Most of the indexes (RICI is the exception) have an established set of rules regarding when and how the index is weighted. These are summarized in Figure 16.


Having examined the different indexes, we can move on to the meat of the matter: How does an investor gain the desired exposure to commodities? As mentioned previously, larger institutional investors can take positions using index-linked products such as swaps and structured notes, or they can build replication portfolios using individual commodity futures. For smaller investors, however, that is not a realistic option, due to the logistical difficulties and scale required to establish and maintain numerous futures positions.

An alternative approach could use index futures, as there are currently futures contracts listed on several of the broad indexes (GSCI, CRB, and DJ-AIG). But again, direct futures trading is impractical for the vast majority of investors. A single GSCI futures contract has a nominal value of approximately $100,000 and would be rolled 12 times annually. A CRB futures contract has a nominal value of approximately $150,000, is thinly traded and must be rolled six times a year. Although a single DJ-AIG futures contract has the lowest nominal value, at approximately $54,000, that contract is also thinly traded. This may result in significant slippage, with positions that are difficult to establish, roll over and exit.

Indirect Investment

As mentioned, many investors have chosen to take equity or debt positions in firms that specialize in direct commodity production or marketing as a surrogate for real asset exposure. The thinking is that price movements in raw commodity prices will be reflected in the valuation of these firms. The problem is that this is not supported by the facts.

Figure 19 illustrates that commodity-based equity share prices are more highly correlated to equity indexes than to real asset prices. The Select Sector SPDR-Energy (XLE) is one of several ETFs which track a basket of stocks from companies in the oil, gas, energy equipment and services industries. As such, it is often utilized as a surrogate for energy exposure. Figure 19 shows that the basket of energy industry stocks that make up the XLE is closely correlated to the S&P 500 stock index, but not to crude oil prices. Obviously, an investor using the XLE as a surrogate for energy exposure would be advised to look elsewhere.

The primary reason for the high correlation to equities is that, in many instances, these commodity industry companies hedge their commodity exposure to better weather fluctuations in raw commodity prices. Simply put, these firms are in the moving business, not the storage business. They run exploration and development operations, not commodity price speculation firms. To the extent possible, they will do what can be done to lessen the influence of raw commodity prices on their bottom lines, as a fiduciary responsibility to their shareholders.

Index - Bench marked And "Real Asset" Funds

There are currently a number of commodity index-bench-marked products offered to the retail market. Although the aim of most of these products is seductively beneficial, investors should be forewarned that the actual execution of the strategy has been an expensive proposition. In almost all cases, the investor is presented with the desired broad benchmark performance. In exchange, however, the investor has to pay very high fees that have a materially adverse impact on that performance.

Figure 18





Contract Value

Open Interest

Open Interest $ Value

Rolls (Annual)

































as of June 30,2005

The RICI is currently offered as the benchmark for a fund with a minimum initial investment of $10,000. In the first year of participation, an investor could pay well over 750 basis points in various fees and expenses. This is not an unusually high threshold for these funds, and that is the problem. The index would have to appreciate by over ten percent for the investor to net the same return as an investment in relatively low-risk T-bills.6

Real asset or specialty natural resource mutual funds present another option for smaller investors. Far too often, however, there are serious drawbacks to the current offerings. Most real asset funds also have notoriously high costs. A sample of these funds reveals that many have load fees of more than 500 basis points and annual expenses of more than 125 basis points. These cost structures present an enormous drag on portfolio performance.

What's worse, oftentimes the holdings in these are not commodities or their direct derivatives; the funds are frequently loaded with equity shares of natural resource firms. As previously discussed, this is the wrong exposure.

Additionally, many of these funds come with the associated problems of all mutual funds: a lack of transparency, realtime pricing and shorting ability.

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