Introduction

It has often been said that investing in commodities is highly risky and provides a wild and wooly ride in the world of investing…however, there are a now a small but growing number of excellent, high-quality index-based commodity funds available that provide a relatively conservative way to invest in commodities. This article explores some of the characteristics and benefits of such commodity index funds.

Relatively conservative are the key words here characterizing these commodity index funds. In general, commodity prices can fluctuate to wide extremes in both the short and long terms. Direct investing in commodities is approached through commodity brokerage accounts characterized by relatively small amounts of highly leveraged margin funds on top of these widely fluctuating wide extremes in prices. The composition and management of commodity index funds attempt to minimize these price fluctuations and provide overall risk management in several ways.

Commodity index funds are currently a small but growing number of excellent, high-quality managed index funds. Managed funds are a bit of a misnomer, as commodity index funds are not actively managed as in regular managed funds; rather, commodity index funds are typically computer-managed, based on monthly closing prices of a fixed-weight portfolio of the nearby futures and forwards contract month of international commodity markets.

The selection and weighting of the portfolio of the specific set of commodities in a commodity index fund are typically reviewed annually or when there is a major change in an industry or even a drastic change in usage of any given commodity. This strategic selection and weighting management provides some overall risk reduction in commodity index funds. For example, the commodity index fund may select crude oil to be in the fund, given its critical importance in the world economy; further, the fund may position crude oil with a heavy weight, from consideration of the increased demand of crude oil by China and the rest of Asia. Similarly for corn – the fund may select corn to be in the fund, given its widespread use worldwide; and further, the fund may position corn with a heavy weight, from consideration of the massive recent growing consumption of meat (chicken, beef, etc…) from China and the rest of Asia resulting in the massive additional requirements of corn as feed for chicken, cattle, etc…and also from consideration of the growing use of corn in the form of ethanol as a substitute for increasingly expensive crude oil in some developing countries like Brazil.

Index funds usually consist of strictly long positions on the contracts. Short positions are usually not taken. As the funds are structured as described in the above, and usually managed by professional and experienced commodity traders and commodity advisors, the index fund is a type of fund quite suitable for investment by investors with limited commodity background.

Aspects of Commodity Index Funds

An excellent white paper by Robert Greer discusses some aspects of commodity indexes(1). The conclusions of the article are as follows:

• total return from an unleveraged (see explanation later) commodity index is positive, on average, and comparable in magnitude and volatility to returns on stocks

• commodity index returns are negatively correlated with stocks and bonds

• commodity index returns are positively correlated with inflation

• commodity index returns are more positively correlated with changes in the rate of inflation

• commodity prices are not highly correlated with each other

Conclusions on commodity index funds are similar in other references – for example, by Adam De Chiara and Daniel M. Rabb. (2)

These aspects are quite interesting given the current state and conditions of the worldwide economy and markets. Stocks and bonds, by various measures, appear to be quite overvalued after a generally long bull market since about 1980. Interest rates and inflation in the largest economies of the world have come down to extremely low levels. Recent measures of inflation, such as the US Producer Price Index (PPI) and the internationally-recognized Commodities Research Bureau (CRB) index of 17 commodities appear to clearly indicate rising inflation. In this environment, given the above aspects of commodity index funds, there would appear to be a strong case for commodity index funds as an attractive asset class now.

Of particular interest is the aspect about commodity index returns being more positively correlated with changes in the rate of inflation – in the current environment of extremely low expectations of inflation and a growing inflationary environment, this more positive correlation with a change of inflation would indicate a very likely potential for significant commodity price increases in the near future.

Summary of Beneficial Characteristics of Commodity Index Funds

To summarize the beneficial characteristics of commodity index funds, here is a list with descriptions of each characteristic:

• long-only – no short positions betting on falling commodity prices

• passive – literally computer-based; just monitoring of commodity prices, as opposed to active in terms of price monitoring and associated ad-hoc or periodic trading

• unleveraged – all the long positions are fully collaterized with T-Bills

• unhedged – no hedged positions (like short positions or put options); all positions long

• continuous switching and rolling over – means that all long positions are covered approximately when the open interest of the nearby futures contract month becomes less than the next futures contract month; the next futures contract month is then bought (again as a long position)

• fund based on a basket of commodities

• percentage mix of basket of commodities – flexible on a long-term basis (for example, if industrial demand slackening from China and India for example, then greater weight towards grains and agricultural commodities)

• frequent and consistently periodic re-balancing – this is important to help reduce volatility in the fund and can also bring as much as an extra 2% in overall fund growth due to statistical fluctuations; one reference(2) mentions the return of one commodity index fund as being about 280 basis points per year; what is meant here is that after every periodic fixed period of time (monthly for example), the fixed percentage weights of each commodity are readjusted to its chosen initial value

• choice of commodities – based on demand growth from China, India, and overall global needs and global growth

Summary of Benefits of Commodity Index Funds

To summarize the benefits of commodity index funds, here is a list of each:

• direct investment in commodities, as opposed to natural resource companies – investing in companies means need to check balance sheets, management, relations with locals, etc…

• inflation protection, especially rises in inflation – anticipated inflation is good for stocks and bonds as it results in high earnings growth, while unexpected inflation may result in negative returns for stocks and bonds; correlation with inflation = 0.23 (1)

• strong correlation with change in the rate of inflation; correlation with changes in inflation = 0.59 (1)

• minimal or negative correlation to stocks and bonds – means when stocks and bonds go down, commodity index funds likely to go up; but does not necessarily mean that when stocks and bonds go up, commodity index funds go down – in this case, likely that stocks and bonds out-perform commodity index funds but that commodity index funds likely perform reasonably well; correlation with bonds = -0.32 (1) ; correlation with stocks = -0.14 (1)

• high investment growth when there is worldwide economic growth – need for new construction, machinery, industrialized products, and associated services

Commodity Index Funds and Indexes

There are a number of commodity index funds available currently; the reader is encouraged to perform individual research on what would be the best and most suitable commodity index fund. Most commodity index funds will track a specific commodity index that is some mathematical summation of a specific set of commodity prices in a pre-defined weight assignment of an associated set of commodities. Examples of some of these commodity indexes are as follows:

* Goldman Sachs Commodity Index (GSCI)
* Commodities Research Bureau (CRB)-Bridge
* Dow-Jones-AIG Commodity Index
* Mount Lucas Management (MLM) Index (financial as well as commodity futures, and includes both long and short positions)
* London Metal Exchange (LME) Metals index
* Rogers Raw Materials International Commodity Index (RICI).

The Bonneuil Report
May 19, 2004
www.bonneuilreport.com
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Many thanks to Robert Greer of Pimco
who provided a review and helpful comments to this article.

(1) The Nature of Commodity Index Returns” by Robert Greer; published in The Journal of Alternative Investments, Summer 2000 [Robert Greer is currently Senior VP and Real Returns Product Manager of Pimco]

(2) The Benefits of Real Asset Portfolio Diversification by Adam De Chiara and Daniel M. Rabb, AIG Trading Group Inc.; published in Euromoney International Commodities Review 2002

© 2004 The Bonneuil Report
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