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Trade of The Month: Commodity Indexes

Although equities are the most popular and natural choice for retail products, commodities are a good niche choice for two main reasons. First, when the increase in value of commodities is very strong, and second as a diversification from equities. Because commodity prices often exhibit complex pricing patterns driven by supply and demand, many commodity indexes have been created in order to provide a more reliable measure of commodity price performance.

All indexes must be ‘investable' to have any real use - that is, subject to a reasonable tracking error, an institution can follow the investment strategy that defines the index and replicate the values of the index in a holding. This requirement is necessary as it will form the basis of the hedging strategy. If a fund or structured product is to be issued linked to a certain index, then the institution needs to be able to create the returns for that index just as if it were a simpler asset such as a stock.

All commodity indexes differ fundamentally from equity indexes because the latter are linked to stocks while the former are linked to futures, as holding the underlying spot commodities is not feasible due to storage costs and other issues associated with physical holdings.

The early indexes were the GSCI (now S&P GSCI) and DJ AIG (now DJ UBS). Both automatically roll from one future into the next (front) future. This can create problems because of the way that front futures price rolls compared to the spot level. The index can suffer significant price impact at the time of each roll, which can markedly affect performance over the long term.

This problem does not occur with equity indexes, because although they typically rebalance stocks in a prescriptive fashion every three months or so, there is no fundamental disadvantage that the index will suffer. Equity indexes mimic investment stock portfolios by holding stocks in the correct ratio and names to follow the index strategy.

The latest generation of commodity indexes have sought to get around this roll effect by investing in a range of futures maturities, often selecting the one that is deemed to be cheapest by some measure or simply diversifying over a range of maturities. This makes it much harder for other market participants to front-run or take advantage of the rolls in the way that was more possible in the simpler algorithms.

Other variants also weight by different commodities in a more sophisticated fashion. Still more complex variations might use long-short strategies, or volatility-control mechanisms.

Equity indexes are usually quoted without the effect of reinvested dividends. This is often an important consideration for structured products because the loss of dividend yield significantly reduces option prices and therefore boosts participation or other product terms. Commodity indexes are usually quoted as excess return indexes, which is the cumulative return over a cash account at the risk-free rate. This represents the return on a position funded by borrowing and is roughly equivalent to the return on the commodity minus the risk-free return. This convention comes from futures markets but its adoption is questionable for structured products as it might mislead investors about product performance. The use of excess return indexes cheapens option prices in much the same way as price-only equity indexes, and has become more or less standard.

In summary, then, while many commodity-based products link directly to underlying commodities, it is often more convenient or representative to use commodity indexes. Because of the nature of commodities, constructing indexes is rather more difficult than constructing equity indexes, with a constant search for more efficient mechanisms. The result is that the structured product market now has many different indexes to choose from for commodity investments.



This article first appeared on www.risk.net/structured-products on 2 June 2011.

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