Commodities Indexing tricks of the trade

Despite a mid-summer sell off that sliced more than 22 per cent off a key benchmark, commodities have been performing extraordinarily well for some time. According to the Standard & Poor’s Goldman Sachs Commodity Index (S&P/GSCI), commodities are up more than 40 per cent over the last year to August 18. Five-year annualised returns topped 15 per cent. And 10-year annualised returns were above 14 per cent.

The index trounced the MSCI World Equity Index, whose total return was down 8.51 per cent over the past year, up an annualised rate of 10.69 per cent over the past five years, and 4.56 per cent over the trailing decade.

With this kind of steady performance, most managers look to maintain some degree of hard asset exposure in diversified portfolios. Thomas M. Idzorek, director of research at the asset allocation advisory Ibbotson Associates, found that over the long term, commodities generated the highest returns of all investments while being minimally correlated to all major asset classes. He also saw that commodities were positively correlated to inflation, thus making them a good hedge against rising prices.

The key issue facing advisers looking for such exposure, however, is how to get it. There are plenty of licensed products that track commodities. But unbeknown to many, their holdings vary greatly, as does their performance. Over the past year, for instance, the S&P/GSCI outperformed the Dow Jones AIG Commodity Index [DJ-AIG] by nearly 24 percentage points. Thus, investors have to be careful when they think they are “buying the market”. In reality, each index is providing variations on the market.

What these indices do have in common is that they track long futures contracts of the actual commodities rather than shares in oil or metal producers. They cancalculate additional yield from the collateral an investor would typically invest in secure short-term government securities.

The S&P/GSCI benchmark is the oldest and most popular investable index that many mutual funds and exchange traded funds have licensed. It is comprised of two dozen energy, industrial and precious metals, and agricultural-related commodities. It is weighted by global production. This means a heavy tilt toward energy, which currently comprises three-quarters of the index. Such exposure is great when oil and natural gas prices are rising, but disastrous when they are falling.

Alternatively, managers can turn to the DJ-AIG, UBS Bloomberg Constant Maturity Commodity (CMCI), Deutsche Bank Liquid Commodity, and the Rogers International Commodity indices.

They vary in several ways. First, they have a different range of holdings and subsector weightings. For example, the UBS Bloomberg CMCI Index has exposure to 28 commodities, the Rogers Index follows 35, while the Deutsche Bank Index has just six. Where the S&P/GSCI has concentrated exposure to energy (75 per cent), the Dow Jones/AIG Commodity index limits any individual sector exposure to 33 per cent. This produces different levels of risk. Long-term annualised volatility of the S&P/GSCI is 19.92; for the DJ-AIG, it is 13.44.

Second, while they all follow futures contracts that require little money down, the way in which collateral for these contracts is invested can vary, depending on the index or mutual fund manager discretion.

This is discernable in the difference between excess and total returns. Gains from the contracts alone are regarded as excess return. Total return is inclusive of collateral yield.

Most indices base their calculation of collateral yield using three-month Treasury bills. However, Mihir Worah, portfolio manager of the Pimco Commodity Real Return Strategy Fund, which tracks the DJ-AIG Index, invests in inflation-linked Treasuries with an average maturity of five years via the Lehman Brothers Tips Index. The combination of Fed rate cuts and higher consumer price inflation over the past year propelled his collateral return up 10.1 per cent, versus 2.8 per cent for three-month Treasuries.

Moreover, Mr Worah believes his fund offers a more complete inflation hedge than most other indices. “Commodity exposure provides protection at the wholesale price level,” he says, “while Tips provide it on the retail CPI [consumer price index] level.”

Third, maturity and management of the futures contracts also vary, affecting volatility and returns. S&P/GSCI relies generally on one month contracts while the UBS Bloomberg Constant Maturity Commodity Index goes out to three years. Gains or losses are generated from the underlying change in commodity prices and when contracts are rolled over. When futures near maturity, they are sold and replaced with longer dated contracts, a process that generates roll yield.

Traditional indices use set contract lengths that roll systematically. Newer variations seek to gain from greater contract management.

Lastly, there is a variety of licensed investment vehicles providing exposure to these indices, including mutual funds, ETFs, and exchange-traded notes. Cost is the key difference between the active and passive routes.

While the institutional share class of the Pimco fund and the Barclays ETN have relatively low annual expenses of about 75 basis points, the retail version of the former has a 5.5 per cent front load and annual expenses of 1.24 per cent.

So far Pimco has earned its fee not only through superior collateral profits but via the outperformance that manager Mr Worah generated by tweaking the index. He maintains the index’s broad sector weightings, in energy and precious metals, for example, but is able to vary his subsector exposure, to natural gas and gold, for example.

Despite the differences, Daniel Nash, head of Morgan Stanley’s commodity index trading group, believes all indices can provide a valuable hedge. “When commodities surge, index exposure can counteract the negative weight rising prices can have on stock and bond markets,” he says.

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Commodities Indexing tricks of the trade