Choose Your Commodity Index Wisely

May 01, 2005

Commodities are booming and commodity indexes are more popular than ever. But the commodity indexing industry still can’t agree on how to create a proper index.

Commodities are hot.  With oil supplies tight and China's growling economy sucking up everything from aluminum to zinc, the prices of many commodities stand at historic highs.

Not surprisingly, investors are eager to cash in on this boom, and commodity indexes are leading the way.  According to Barclay's Global Investors, institutional money tracking the leading commodity indexes is up 400 percent since 2002, to $40 billion.  U.S. mutual fund flows are even stronger, with assets rising from just $300 million to more than $7 billion over the same timeframe.

For new investors interested in commodities, the appeal of indexing is obvious.  Few investors understand the commodities industry - Quick: What's the difference between a soybean and an azuki bean? - and many figure that a commodities index will provide broad exposure to the booming commodities market.

But the commodities indexing industry is still in its infancy, and has yet to establish basic "best practices" for how to construct a proper commodities index. As a result, the leading commodities indexes offer radically different exposures to the commodities marketplace.

 Ranga Nathan surveyed the differences between five leading commodities indexes recently in the Journal of Indexes, and I won't duplicate his efforts here.  Instead, I'll focus on the one question that stands at the center of the commodities indexing debate: How do you weight components within a commodity index?

What's the Market Capitalization of Wheat?

In the equities market, two broad market index funds will provide similar returns to investors.  That's because the indexing industry has settled on one basic methodology to weight companies within an index: their market capitalization.   There are important differences between index families, and returns do differ.  But these differences lie at the margins.

Not so in the commodities business. The five major commodity indexes offer radically different methodologies for weighting components, and the resulting indexes provide radically different returns. Depending on which index you choose, for instance, you could be putting as little as 18 percent of your money into energy products … or as much as 75 percent. 

The problem is that there is no equivalent to "market capitalization" in the world of commodities: After all, what's the market capitalization of wheat?  As the differences between the indexes show, there's no easy answer.

Generally speaking, a "fair" weighting methodology for any investable index must accomplish two goals: 1) Relate the "importance" of each index component to the economic sector covered by the index; and, 2) Relate the investment opportunity provided by that component.

The equity industry is fortunate in that market capitalization accomplishes both goals.  Within the commodities industry, however, indexers have - so far - been forced to take sides.

Below, I've highlighted how each of the five major index providers approaches the question of how to weight a commodities index, and what impact this has on their index.  The debate on best practices is ongoing, and will become of greater and greater importance as more investors pile into the commodities sector.

The Contenders

The history of commodities indexing traces its roots back to the early days of financial journalism.  Milton Jiler was a commodities reporter for the New York American in the 1930s when he realized that there was no unified publication tracking the performance of commodities prices.  He formed the Commodities Research Bureau to fill that niche, and in 1956, that group introduced its breakthrough index - the CRB.[1]  That index has been altered and tweaked over the intervening half century, but it remains one of the three most closely watched commodities indexes in the world.

In the early 1990s, two major commodities indexes were launched to improve upon the perceived flaws in the CRB: the Dow Jones AIG Commodity Index (DG-AIGCI) and Goldman Sachs Commodity Index (GSCI). A fourth index was introduced in 1999 by legendary investor Jim Rogers[2]: the Rogers International Commodities Index (RICI).  Indexing giant Standard and Poor's rounded out the field in 2001 when it introduced its own index, the Standard and Poor's Commodity Index (SPCI).[3]

To make comparisons easier, I've grouped the individual commodities within each index into six groups:

  1. Energy (oil, natural gas, etc.)
  2. Grains/Agricultural (wheat, soybeans, corn, etc.)
  3. Industrial Metals (aluminum, copper, etc.)
  4. Livestock (cattle, hogs, etc.)
  5. Precious Metals (gold, silver, etc.)
  6. Softs[4] (coffee, sugar, cocoa)

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