Riding The Wave

September 01, 2005

Total Return Index

The Total Return Index takes the underlying futures contract as proxy a step further. When investing in futures contracts, investors are required to post margin
in order to establish and maintain positions. The funds posted as margin are invested in government securities and generate a return. All of the Total Return Indexes calculate this portion of return based on current 90-day U.S. Treasury bill rates (90-day T-bills). The return on collateral from the margin account is compounded at a regular interval (which can vary between the indexes).

The Total Return Index represents the performance of the Continuous Contract Index with the inclusion of these collateral returns. Thus, it more closely tracks the investment performance of the collateralized positions.

For a portfolio manager, this collateral return is an extremely important component of the index construction. Generally speaking, the required futures margin, which is usually held as T-bills, is approximately 20 percent of the notional value of the required exposure. The balance of the funds are also calculated to the return of 90-day T-bills, but are available for enhanced strategies.

As an example, consider the manager who has to gain $100 million of commodity index exposure. The actual exposure gained by long positions in the underlying futures would require about $20 million of collateral in a margin account. This position provides the continuous contract portion of the return. The remaining $80 million is calculated as a long T-bill position with the associated returns. In practice, this portion of the portfolio may not be invested in T-bills. By taking alternative positions, an astute portfolio manager may generate returns in excess of the current T-bill rate and generate additional alpha for investors.

Replication Index

Indexes that are calculated geometrically can also provide what is known as a Replication Index.5 Replication is the return that a passive indexer would earn by replicating the index with the underlying components. Geometric indexes maintain equal dollar weightings across the various constituents. Because of this, there is a need to continually rebalance the portfolio. The Replication Index assumes a portfolio is rebalanced at the end of each day to the original dollar weights, and that the resulting rebalance returns are reinvested back into the index.

Index Return

The concept of "return" when discussing commodity indexes is more nuanced than most investors realize. It is not simply the cumulative change in prices of the component commodities.

The easiest way to view the total return of a commodity index is to look at the sources of that return. Commodity index return can be broken into several distinct components. These components are the underlying price movements, the roll yield and the collateral return.

Figure 9

Index

Calculated Return Based On...

Note

Price Index

Price change of underlying commodity prices.

Futures prices used as proxy; not investable.

Continuous Contract

Takes futures roll into account when determining returns.

Uncollateralized (leveraged) return.

Total Return

Continuous contract + Collateral Return

Fully collateralized return.

Replication Index

Continuous contract + Collateral Return + Rebalance Return

Not available for arithmetic indexes.

Underlying Cash Price Changes / Spot Yield

It should go without saying that the change in value of the individual components of the basket will influence the overall price of the basket. The factors affecting these prices have been discussed previously. Suffice it to say that the whole is in fact equal to the sum of the parts.

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