When an index is formulated, there are several important matters that providers take into consideration. A potential investor should understand these issues are and what effect they can potentially have on the performance of the chosen vehicle.
The most obvious difference between the various indexes is in their composition. When choosing the constituents and their concentrations, index providers take many factors into account. As discussed, most indexes use futures contracts as the basis for index pricing, due to their price transparency and availability for hedging. The drawback is that this limits the index basket to those commodities that have actively traded futures contracts. Currently, there are no liquid contracts for coal, steel or chicken futures, among others.
Each of the index providers attempts to strike a compromise between representability and tradability. At one extreme is the RICI, which has 35 constituents, including azuki beans, wool and rubber. This is good in terms of representing a world basket of consumption goods, but it makes the index more difficult to replicate. Silk and soybean meal each contribute just 0.15 percent to the overall valuation. In fact, the smallest 16 components comprise only 12 percent of the index value. This may be viewed as diversity at the expense of expediency.
Liquidity of Constituents
The liquidity of the underlying futures contracts should be a concern for investors and product providers. Several of the indexes have rules that limit constituent inclusion based upon liquidity requirements. Minimal liquidity thresholds ensure the ability of market participants to easily (and cheaply) hedge their exposure. It also ensures that market pricing is current and adequately transparent.
The other concern when discussing the liquidity of the underlying constituent futures is the risk of an index representing an extreme percentage of a commodity's open interest . Several of the more marginal commodities held by some of the indexes are thinly traded at best. Low daily volumes and open i n t e rest amounts should be viewed with trepidation. The risk is that a high concentration of the open interest will be associated with a particular index, which could create price inaccuracies or operational difficulties related to relative position sizes.
After deciding what commodities to include, the index provider must then decide on what weights each constituent will comprise in the overall index. Once again, the index providers have different approaches.
Keep in mind as well that the price movement of the individual components within a sector will tend to move in unison. For this reason, sector representation should also be evaluated.
Number of Components
The total number of components is also important. Once again, the balance is between representation and operational efficiency. As the number of components increases, the basket may become more representative of consumption patterns, but the overall complexity and expense of position management activities will increase.
Conversely, too few constituents will not provide the requisite diversification, and will lead to an index that is more akin to a speculative position than a component in a balanced portfolio.
Domestic vs. International Exposure
Several indexes include non-U.S.-listed constituents in their baskets. This can be beneficial, providing investors with a more representative proxy, but it is not without trade-offs. The primary problem is that time zone differences can make the actual management of the portfolio more difficult.
Another concern is currency conversion. Although many non-U.S. listed futures are priced in U.S. dollars, not all are. The inclusion of non-dollar based products introduces the risk of adverse currency fluctuations.
In many cases, non-U.S. components are highly correlated to their North American counterparts (i.e., Brent Crude traded in London vs. WTI Crude traded in New York). If there is not a suitable difference in representation, the inclusion of non-U.S. components may not be warranted. Fo reign commodity representation should serve a higher purpose than as a marketing angle.