Once institutional investors have accepted the arguments for investing in a commodity index - diversification, low correlation with other asset classes, promise of high returns - how do they gain exposure?
There are a number of routes into commodity indices. The simplest is an index fund, which tracks a selected commodities futures index. There are currently few such funds on the market. The best known is the index fund launched in 1998 by Jim Rogers, co-founder of the Quantum Fund, and author of the book ‘Adventure Capitalist’.
The fund tracks Rogers’ own index, the Rogers International Commodities Index, which he designed to reflect the price movements of raw materials worldwide.
The Rogers fund gives investors exposure to a basket of 35 commodities. The value of each component of the basket is based on the monthly closing prices of the corresponding futures and forward contracts, which are each valued as part of a fixed weight portfolio. The fund is open to both institutional and retail investors.
Another route into commodity indices is through mutual funds. The largest of these is the PIMCO Commodity Real Return Strategy Fund, with $5bn (e4bn) in assets. The fund uses swap agreements to gain exposure to changes in the Dow Jones AIG Commodity Index (DJ/AIG-CI), composed of 20 futures contracts on physical commodities traded on US and London exchanges.
Commodity indices typically include a rate of return on the underlying collateral that is roughly equivalent with money market rates. PIMCO invests the portfolio assets that serve as collateral in inflation-linked bonds (TIPS), which offer returns in real, not nominal, terms.
A newer route is through exchange traded funds (ETFs), baskets of securities that are traded like individual stocks. Until recently there were no ETFs linked to commodity indices. But recently AXA Investment Managers and BNP Paribas launched the world’s first commodity ETF. This is based on the Goldman Sachs Commodity Index (GSCI), composed of 24 commodities across four sectors – energy, metals, agriculture and livestock.
AXA and BNP Paribas say that, by investing directly in the most liquid underlying futures contracts, the GCSI provides investors with a true exposure to commodity returns.
Philipp Vordran, chief executive officer of Credit Suisse Asset Management in Germany, points out that rising oil prices have rewarded investors in the GCSI. “If you are extremely optimistic on energy then the GSCI is certainly the right one to pick. If you had invested $100 with the CRB commodity index three years ago, your performance would have been 50%. If you had done the same with the GSCI your performance is close to 100%. The reason for that clearly is the very high portion of energy in the GSCI, which has over 70%.”
The preferred route into commodity investments for large institutional investors is through commodity index swaps, says Kelley Kirklin, consultant for Banque AIG, co-sponsor of the DJ-AIG Commodity IndexSM. An institutional investor can keep his money in a money market fund of some kind, and transact a swap overlay where he pays a LIBOR-based or T-Bill-based interest rate against receiving (or paying) the percentage change in the commodities index since the last re-set.
At the end of a period, if the commodity index was to go up 5% and interest rates were 1% the investor would receive a net amount of 4% (5% from the increase in the commodity index less 1% from the notional interest rate). The investor would also earn something close to 1% on his money market fund.
This form of investment is attractive, Kirklin says, because of the ease of getting in and out. An index swap is almost like an FX position. It is rolled over on a periodic basis and it can be cancelled.
“It’s a liquid and transparent way for some institutions to enter the market, particularly for a strategic rather than a tactical allocation. The capital’s not really switching hands and this means that the money invested remains very easy to re-allocate away from commodities if desired.”
The swap route into a commodity index can be managed with or without the use of an asset manager, Kirklin says. The additional fee to the asset manager for managing the swap can be well spent, especially when a pension fund doesn’t have an International Swap’s & Derivatives Association (ISDA) contract in place to contract swaps directly with a derivative dealer.
The larger, more sophisticated pension funds will generally put an ISDA in place with derivative dealers and transact their swaps in the market directly, and perhaps separately award a mandate to a money market manager to look after the cash investment.
Another option, particularly attractive to smaller institutions, is a note linked to a commodity index. The principal redemption of the note will frequently be partially or fully protected. The note may have a low or maybe a zero coupon, and investors will forgo the coupon and get in exchange a call option on the commodity index. So they are principal protected and receive upside on the commodity index.

In some markets, including Germany, the concept of certificate is used quite often. A certificate is really just a funded swap. The investor places the cash into the certificate and earns interest while getting exposure on the underlying index. Certificates are generally not principal protected.
Ellen Sullivan, an independent consultant in specialty products for institutional investors, covering primarily the German-speaking market, says there is growing interest from institutions in structured notes linked to commodity indices.
Sullivan has been involved in developing and marketing a product for the German institutional market. “The plain vanilla product is an index linked note with a seven-year maturity, it is easy to figure the Value-at-Risk over seven years. Anything longer and it gets a little more complicated
The product can be customised to suit the client’s requirements, she says. “It can have a capital guarantee, although it doesn’t have to. Likewise it can have a coupon although it doesn’t have to. Some institutions, for regulatory reasons, will need to have a capital protection and some will need to have a coupon, even if it is only 1%.”
Sullivan says that the aim has been to keep the product simple and cost-effective. “If all that clients want is to ensure that they have exposure to the commodities market, then this is the most efficient way to do it. Structured products of passive instruments make sense because they’re effective and they’re cheap.”
Yet institutional investment in commodity indices has been relatively slow to develop in some parts of Europe. This is not for want of derivative dealers, says Kirklin. “There are now several commodity index swap providers, including Banque AIG, and this is quite a competitive market.”
Regulation is perhaps the greatest obstacle to the development of a market in commodity index investments. A number of EU countries, including Austria, France, Germany, Italy and Spain, exclude the possibility of swap transactions “to obtain the performance of an index underlying hedge funds, commodities and futures indices”.
There is some question about whether UCITS III-compliant investment vehicles exclude the possibility of commodity-linked investments. Products using off-exchange derivatives to get the return of commodity indices are in principle prohibited under UCITS III.
Yet some regimes, notably Luxembourg, are prepared to accept funds that invest in commodity indexes. In May, Activest, the investment management subsidiary of the German bank HVB, launched a Luxembourg authorised mutual funds that tracks the DJ/AI-CI.
Johann Fuerstenberger, manager of the Activest commodities fund, says that Activest chose to invest in a commodity futures index rather than directly into physical commodities to reduce the risk through diversification.
“Commodities are very volatile. A concentrated commitment in only one or two raw materials such as oil or gold can lead to too extreme movements in the portfolio.
“We decided on the DJ/AI-CI because it represents a balanced mixture from energy, metals and agricultural products. Other commodity indices are usually strongly biased towards energy.”
Activest describes its fund as a ‘pioneer’ in the EU. Certainly it seems likely to encourage European investors to look more seriously at commodities as an investment option.