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Forging a New Commodity Index

Why a momentum-based long/short approach makes a better benchmark.

Paul Kaplan, 08/04/2008

Traditional, long-only commodity indexes only tell half the story. Why a momentum-based long/short approach makes a better benchmark.

Commodity prices and the level of investment in commodities strategies have risen significantly in the past few years. With more investors focusing on commodities, more money is expected to pour into commodity indexes through exchange-traded products, mutual funds, and futures. Commodity-index-linked investment vehicles now command approximately $185 billion, and this trend seems unlikely to abate.

There is reason to question, however, how well investors are being served by these traditional long-only commodity indexes as either benchmarks or proxies for investment products.

Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the commodities asset class. While we do not offer an approach to taking pure beta exposures in this study, we assert that new passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity indexes are better benchmarks for active strategies.

No Such Thing as Commodity Beta
For many asset classes, it is very easy to take a pure beta exposure--multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500, and Wilshire 5000, for example, are representative of the broad stock market and have similar risk and return characteristics; the Citigroup Broad Investment-Grade, Lehman Brothers Aggregate, and Merrill Lynch U.S. Domestic bond indexes mirror the wider fixed-income market and perform alike.

Yet for commodities, fewer choices and more disparity exist among the index options. The risk and return characteristics of three commonly used commodity indexes--the S&P GSCI Commodity Index, Dow Jones AIG Commodity Index, and Reuters Jefferies CRB--vary greatly. Dramatic differences in constituents and weighting schemes and rebalancing rules are likely the cause for the performance differences in the commodities indexes. The S&P GSCI, for example, has about double the weighting to the energy sector as have the Dow Jones-AIG and the Reuters Jefferies, and only one third of the weighting to agriculture.

Sources of Excess Return
Professional commodity-trading advisors often take both long and short positions in commodity futures. Why? Because they know that long-only strategies provide inadequate investment exposure to commodities.

A futures strategy generates excess return from two sources: changes in futures prices and the roll yield. The roll yield, which can be positive or negative, results from replacing an expiring contract with one farther away from expiration. This allows the trader to avoid the physical delivery of the commodity yet maintain positions in the futures markets.

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