UBS executive director explains how index is designed to distribute commodities more uniformly.
All commodity indexes are not the same. But what are the differences between the S&P Goldman Sachs Commodity Index, the Reuters/Jefferies Commodity Index, the Dow Jones – UBS Commodity Index, the Rogers International Commodity Index, the UBS Bloomberg CMCI Index and the Deutsche Bank Liquid Commodity Index? Hard Assets Investor continues its ongoing series examining how the major commodity indexes work by interviewing the people and discussing the strategies behind them. In this installment, Managing Editor Drew Voros talks to John Kowalik, executive director in commodities structuring and marketing for UBS, who oversees the Dow Jones-UBS Commodity Index.
Previous “Behind the Index” interviews:
Hard Assets Investor: What are the differences between the Dow Jones-UBS Commodity Index and the other major commodity indexes?
John Kowalik: The highlight of the Dow Jones-UBS Commodity Index really is that it has the greatest diversification and a more uniform distribution across commodities than other indexes. Even though there are only 19 components in the Dow Jones-UBS Commodity Index, the fact that it puts a minimum allocation of 2 percent for each of the components gives you a substantial risk allocation for each component.
If you look at other commodity indices, you find that they may have 25 or 30 different components. As many as eight or a dozen of those components have contributions of less than 0.5 percent. And then you will find that they are concentrated in various commodities and sectors. S&P GSCI is very petroleum concentrated. We have a broad variety of commodities. The diversification of having a minimum of 2 percent in each of the components gives it — in terms of average or deviation from average — allocation that is narrower than any other index.
HAI: What’s the maximum allocation for a commodity?
Kowalik: No single comodity can be more than 25 percent.
HAI: Can you describe the nature of the futures contracts? Are they front months?
Kowalik: For the liquid commodities — the metals, the energy contracts — they roll every other month to the third contract out. It’s not entirely in the front of the market like you have with the S&P GSCI. We get some performance of those particular sectors relative to those commodities that are exposed right in the front.
HAI: What is the percentage breakdown of each commodity in the index?
Kowalik: There are weights that are established once a year. Obviously, the weights diverge on a daily basis as the commodities perform. There’s 31 percent in energy, about 30 percent in agriculture, 18 percent in precious metals, 16 percent in base metals, 6 percent in livestock and the balance would be in agriculture, including soybean oil. And I want to point out that the precious metals exposure of around 18 percent is probably higher than any other index, which in this particular market environment has turned out to be a real benefit.
HAI: Is the index production weighted?
Kowalik: It is not purely production weighted like the S&P GSCI.
HAI: And the index is rebalanced once a year?
Kowalik: That is correct. There are target weights that are established once a year. We will be announcing — probably within a month — the new effective weights for the index, which will be implemented in January.
HAI: How do you determine, for instance, how much wheat is included in the index?
Kowalik: There are various guidelines. No commodity can be more than 25 percent and no group of commodities, like energy or precious metals, can be more than 33 percent. No commodity can be less than 2 percent. But before you get to that step, you are just looking at the production-weighted data over a certain time period. You start with those constraints and then you move forward. So the weight of any other commodity is following that methodology.
These things can get fairly complex. Often it is hard to describe it in two pithy little words about how things are exactly weighted. It’s based on liquidity and production as well as a number of different components that all come into play.
HAI: What is the time period you look at in terms of history of a particular commodity? Is it two years, three years, five years?
Kowalik: It’s five years, and it may start a year back because it takes a while to get all the data.