Merrill Lynch Launches Commodity Index

June 28, 2006

It’s amazing what a little money and competition can do: Merrill Lynch enters the commodities indexing space with yet another innovative approach.

The rush of money into the commodities sector is spurring an indexing renaissance that shows no sign after abating. During the 1980s and 1990s, the sleepy commodities indexing space was dominated by the three grande dames: the CRB Index, the Goldman Sachs Commodity Index (GSCI) and the Dow Jones AIG Commodity Index (DJ-AIG). But ever since the Internet bubble popped and investors began flocking to commodities, indexers have been rushing to market with "new and improved" ways to track the asset class.

What is interesting is that, by and large, these new indexing methodologies don't claim to provide the most accurate measure of the commodities market - whatever that means.  Instead, they aim to capture the best possible performance, and to make it easy to create investable products tied to the indexes.

The latest announcement comes from Merrill Lynch, which launched a new commodities index last week with a novel methodology that it says can add as much as 3.4 percent per year to the performance of its index, as compared to traditional commodity indexes.  The new index is called the Merrill Lynch Commodity eXtra Index, and you can bet that Merrill Lynch is dreaming up investable products for this index even today.

The Merrill Lynch Commodity eXtra Index

In many ways, the quest for greater performance echoes the movement in the equities space towards fundamental indexing, where indexers are using different weighting methodologies in a quest to outperform traditional cap-weighted indexes.  In the commodities sector, however, indexers are not using weighting differences as much as changes in the "roll strategy."

As discussed extensively in this space, commodities indexes hold futures contracts that must be "rolled over" from time-to-time.  Typically, the indexes hold what's called "front-month contracts."  These are contracts that are expiring in the current month - for instance, right now, the "front-month" contract for oil expires in July.  If you hold this contract to expiration, you'll take delivery of liquid crude oil at a port in Oklahoma. (Have fun!)

Funds (and the indexes they track) don't want physical oil, so they typically sell this front-month contract and buy the "second month" contract - in this case, the one expiring in August.  They usually do this over a five-day period prior to expiration.

The new Merrill Lynch Index takes a different approach.  For one, it holds the "second month" contract and rolls it into the "third month" contract, rather than rolling from the "front month" to the "second month."  Recently, this second-to-third month roll has been more favorable for investors than the first-to-second month roll.

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