Merrill Lynch Launches Commodity Index

June 28, 2006

This is not a new innovation. The OIL-W crude oil ETF which launched in London in early May uses the same second-to-third month methodology, and the Deutsche Bank Commodities Index - the bogie for the U.S.' only commodities ETF, ticker DBC - has a slick mechanism that lets it pick the most favorable roll combination from a variety of choices.

Merrill Lynch, for its art, says that rolling from the second-to-third month has historically been the most optimal combination, improving the roll yield without sacrificing liquidity. Beyond the third month, it warns, liquidity falls by the wayside.

The second wrinkle in the Merrill Lynch index, however, is a new innovation: Rather than rolling contracts over a 5-day period, as is the norm, the index rolls them little by little over a 15-day session. This "semi-continuous roll," according to the company, contributes to the excess returns.

"[W]e have also done extensive quantitative work focused on extracting alpha from the commodity contract rolls," the company says in its promotional materials. By exploiting the mechanical inefficiencies on the contract rolls, the back-test yields superior historical performance when compared to other commodity indices. In addition, because of the lengthy rolling window, we believe it is unlikely that MLCX will create quantitative inefficiencies that could be exploited by other market participants."

Weighty Matters

To weight components in the index, Merrill Lynch combines the two classic inputs in commodities weighting: Liquidity (the size of the financial market for the futures contract) and the importance of the commodity in the global economy.  That's similar to the approach taken by most other commodity indexes, although each weights the two components differently, and some ignore one component or the other altogether.  See this feature for a primer on the differences.

The index includes a nice mix of 18 components, with sector baskets capped at 60 percent of the total weight. The only sector that runs up against this cap, not surprisingly, is energy.  The components and weights are:

Energy Grains & Oilseeds

Industrial Metals

Softs

Precious Metals

Livestock

Crude oil
27.39%

Wheat
6.25%

Cooper
5.11%

Sugar
2.94%

Gold
3.49%

Live Cattle
3.87%

Gasoline
12.17%

Corn
3.99%

Aluminum
4.67%

Coffee
1.54%

Silver
0.41%

Lean Hogs
1.71%

Heating oil
11.80%

Soymeal
1.84%

Nickel
1.64%

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Natural Gas
8.63%

Soybeans
1.30%

Zinc
1.26%

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Total 60%

Total
13.39%

Total
12.68%
Total
1.54%
Total
3.90%
Total
5.54%

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