Riding The Wave

September 01, 2005

Futures As Proxy

Most of the published commodity indexes use exchange-traded futures and forward contracts as proxies for the physical commodities. Futures contracts are agreements to deliver a standardized asset (grade, type, location, etc.) at a given price and time in the future. In practice, the vast majority of future positions are used for hedging purposes and are liquidated prior to delivery.

Futures are used by index providers for a number of practical reasons: They are standardized, hedgers have access to the markets and prices are transparent and disseminated instantaneously.

Figure 8

GSCI Components and Dollar Weights (%)

Sector

1/8/05

7/7/05

Difference

Energy

66.70%

76.79%

+ 10.09%

Agriculture

16.38%

10.73%

- 5.65%

Livestock

7.03%

4.85%

- 2.18%

Industrial Metals

7.54%

5.93%

- 1.61%

Precious Metals

2.35%

1.70%

- 0.65%

Total

100.0%

100.0%

 

Source: Goldman Sachs

Gaining exposure to commodities without listed future s is more problematic. Physical commodities can be logistical night mares. High storage costs, slippage and spoilage, geographic constraints and a host of other issues work against involvement by non-professionals. Swaps and commodity-l i n ked notes are an option for institutional investors, but also involve costs that must ultimately be borne by the investors .

While the use of futures is appropriate from a pragmatic standpoint, it is not without drawbacks. Chief among these is that the indexes are limited to commodities for which there are liquid futures contracts. Some important commodities are, as mandated by index rules, omitted. Futures positions also must be rolled from expiring contracts to more deferred ones (see the later section on backwardation/contango).

Types Of Indexes

When we speak of commodity indexes, there are actually several different ways to look at the data. For this reason, most index providers compile and report on a series of individual measures for a given index-in effect, creating multiple versions of the same index.

Price Index (aka Spot Index)

The Price Index measures the price movements of the underlying commodity futures spot contracts. It is not a measure of investment performance, and as such, is useful simply as an indication of underlying price trends. Spot indexes cannot be readily compared to their investable counterparts.

Continuous Contract Index (aka Excess Return)

As futures contracts expire, the indexes must roll positions into more deferred contracts. The Continuous Contract Index smoothes the price movements associated with these rolls. It is a measure of the dollars/returns associated with the price movement in the index. It does not account for the return associated with margin accounts, and can be viewed as the return on an uncollateralized, or leveraged, commodity investment.

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