The past few years has seen tremendous institutional investor inflows into commodities. Most investors have chosen to adopt a passive exposure to begin with. It means that choosing a commodity index is one of the most important decisions that an investor can make.
It is sometimes easy to forget that commodities, and commodity indices, are nothing new. The first commodity index, the Commodities Research Bureau, can trace its roots back to its launch in 1957, when it traded on exchanges in the US and Canada, for example. Nearly half a century later, the index has undergone significant changes, has a different name, but is still one of the leading products in the market.
What has changed however is institutional appetite for commodities. Most are making their first allocations to the asset class, and have chosen to have passive exposures rather than make active plays. Indices, which replicate a basket of commodities futures contracts, and are rolled forward over time, allow investors broad diversification to an asset class that would otherwise be problematic, both in terms of delivery of physical assets, and of the specialist knowledge required to make investments.
Investment into commodity futures has grown at a phenomenal pace in the last five years, and indices are raking up capital and market share. But some are faring better than others.
“At its heart, a commodity index is just an amalgamation of futures contracts. The key decisions when constructing one are what contracts to include, what weightings, and whether you introduce some sort of rebalancing into the index,” explains Eliot Geller, vice president of Jefferies Financial Products, the Connecticut-based firm which recently collaborated with Reuters to revise the CRB index, which has been renamed the Reuters/Jefferies CRB Index.
These construction and methodology decisions affect both the returns, and the exposure institutional investors will have to the market. Returns varied from 10.55% to 21.98% in the first three months of this year alone, depending on which index was selected, for example, while exposure to energy varied from less than 20% to more than 70% of the index. It means that investors must understand how the indices are constructed and decide which is the most appropriate.
The most popular index in the market is the Goldman Sachs Commodities Index, launched in 1991. It includes a large universe of commodities but with a large energy concentration (76.26% as of July 15 2005) because it is production weighted.
“We would argue that having a production weighted commodity index is the analogue to the market capitalisation weighting for equities,” argues Arun Assumall, who is responsible for marketing the GSCI in Europe. And market participants seem to agree – with the entire market estimated to stand at $70bn (E57bn), the GSCI holds the lion share, of $50bn (although Barclays Capital has this figure closer to $35bn) using the index, says Assumall.
Still, the GSCI is not without its critics. One competitor points out that because of its energy focus, other sectors in the GSCI have little bearing on price movements and performance, and that gold, which is significant to the global economy, is underweighted substantially.
Assumall dismisses the criticism. “Most investors acknowledge that there are strong diversification benefits from adding commodities into their portfolios. These diversification benefits are in fact driven by the energy complex. Over the long-run, returns from the energy sector have exhibited the greatest negative correlation with financial assets. Returns from the energy sector have also been the most positive, a trend we expect to continue over the five-10 year horizon,” he says.
With the GSCI accounting for so much of the market, it is hard to see where other indices stand. Investors say they like the GSCI because of its transparency and replicability, while other indices are struggling to catch up. The GSCI has a far greater share of the market than the second most popular index, the Dow Jones/AIG Index, estimated to have $12bn, for example. And combined, the two indices hold over 85% of the market, meaning that other players have less than $10 billion between them.
The DJ/AIG was launched in the late 1990s to address concerns about the high energy concentration in the GSCI, and reduces energy weights in exchange for larger agricultural weight. No sector can account for more than a third of the index. However, Dow Jones/AIG had its major breakthrough when Pimco, the bond manager, decided to use and promote it. Without Pimco, it would not have seen so much success.
“The Dow Jones/AIG index was late, but had a phenomenal run up because one client, Pimco, liked it a lot, and created a fund which attracted inflows of about $10bn in just over two years. Although Dow Jones came late into the game, their index promoters were lucky they found a client who successfully promoted the index,” says Torsten de Santos, head of commodity investor solutions at Barclays Capital.
He points out that other indices, (The Reuters Jeffries CRB Index, the Rogers International Commodity Index, Deutsche Bank Liquid Commodity Index, Standard & Poor’s Commodity Index) have fared less well with institutional clients, who are concerned about liquidity. “For an institution, liquidity becomes very important. It is unlikely than an institution which wants to invest a large sum, say $1bn, would choose an index with less than $1bn in it already.”
Unsurprisingly, smaller index providers disagree about institutional interest. “We are providing a range of products, and we are able to offer 15 structured products through deals with banks,” says Stephan Wrobel, vice-chief executive officer of Diapason Commodities Management, which was set up by Jim Rogers, former co-founder of George Soros’ Quantum Group in conjunction with Equinoxe Partners in 2003.
The Rogers International Commodity Index, launched in 1998 by Rogers, has about $2bn in capital following it, but Wrobel points out that investors will be attracted to its large array of products, and focus on investments. The index is broadly diversified with 35 different commodities, including Azuki beans and raw silk, and aims to reflect the current state of international trade and commerce, according to Barclays Capital.
Wrobel dismisses criticisms that it is an index more suitable to high net worth clients who are attracted to the Rogers name. “We have been very active in the structured products market and we have pension funds, insurance companies, large family offices, private banks. We’re not geared only to the high net worth market,” he says. Wrobel also points out that the index, with a compound annual rate of 18% since inception, has posted some of the strongest returns of all its competitors.
It is an argument that de Santos dismisses. “Institutions worry less about relative performance, they worry about liquidity, technical construction, and the ability to hedge,” he says.
He also believes that investors may move away from commodity indices into other products, now that the market can absorb bigger volumes. “Indices were very important to get the interest going into the asset class, and offer clear, reliable, and cheap investments, but banks like us and others have responded to investor demand wanting more sophisticated alternatives. Perhaps there is currently more value if you construct a basket of commodities or an exotic structure.”
Others believe that the market will see some division, just as traditional markets have done. “The evolving thinking on investing is, if I want index exposure, I shouldn’t pay high fees to a mutual fund, I’ll just get an ETF for index exposure. If I want active exposure, I’ll go to a hedge fund who has demonstrable pure skill in the asset class,” says Hilary Till, co-founder of Premia Capital, the Chicago-based CTA player.
But a lot is riding on the belief that commodities will continue to see the same inflows as it has done in the past few years. Richard Cooper, a consultant with Mercer Investment Consulting, does not believe this will be the case. “I’m not convinced that there is going to be a huge uptake by pension funds. People will be conscious that there has been a phenomenal run already,” he says.