In a move which extends its businesses beyond equities, Standard & Poor’s has come up with a new commodities index.
There is no shortage of heavyweight commodities benchmarks in the marketplace, with Goldman Sachs Commodity Index and the Dow Jones-AIG Commodity Index already in broad use. But S&P sees some real advantages to its new yardstick. A key feature of its new marker, it says, is that it is geometrically calculated, whereas these two competitors use an arithmetic methodology.
S&P says geometric index calculation is a form of “disciplined investing”. Because of this form of calculation, it says the SPCI is effectively rebalanced real-time, maintaining constant dollar exposure across underlying commodities.
Geometric methodologies have been widely used in price index calculations – they are used perhaps most notably for the US Consumer Price Index and Producer Price Index. The methodology implies that each commodity included in the index has a constant value share in the index at all times.
Because of this effective real-time rebalancing, the index is forced to buy individual commodities when they are low and sell them when they are high.
This rebalancing, says S&P, leads to trading opportunities between the index futures and futures in the underlying components. This enables the futures contract to trade at a discount to fair value, and this has the effect of ensuring liquidity in the index futures contract, the company says.
Apart from all this, a geometric methodology typically leads to lower index volatility compared to those indices which are calculated arithmetically, it says. So investors might prefer it from the point of view of risk minimisation.
Commodity weights within the SPCI are also adjusted to remove possible double counting between upstream and downstream commodities. Some commodities included in the index are actually inputs for other downstream commodities. For example, crude oil is an input in the production of unleaded gasoline, but both are index components.
In this situation, downstream commodities are included in the SPCI at their full weight and the index weights of upstream commodities are cut to reflect the extent to which they are embodied in the downstream products, says S&P. This elimination of double counting helps investors by making for a clearer pricing picture for the asset class, it said.
Unlike other commodities indices, gold is excluded from the SPCI. S&P takes the view that gold is a financial commodity and that its industrial use is limited. So S&P argues that the exclusion of gold makes the index a more precise asset class benchmark.
Another advantage of the SPCI over competitor indices is that it is weighted by the dollar value of commercial open interest rather than world production averages. This means it avoids being significantly overweight in energy commodities, says Melinda Chu of S&P Index Services.
And because the SPCI includes only domestic commodities — not London metals and Brent Crude – the hedge is easier for a US traded index futures contract, she says.
The New York Board of Trade is launching futures and options contract this autumn based on the new S&P index. Mark Fichtel, president and CEO of the NYBOT, said the geometric rebalancing of the SPCI created strategic futures trading opportunities. This, combined with S&P’s “impeccable reputation” would encourage investors to take advantage of the benefits of commodities in an investment portfolio, he said.
The NYBOT SPCI futures contract will list six active contract months – January, February, April, June August and November. S&P points out that having just one index futures contract for 17 commodities has benefits for investors in terms of lower costs and better transparency.
The new futures and options contracts would also allow investment managers to index a proportion of funds and target specific underlying markets, it said.
Following this initial product launch, S&P says it hopes to see an exchange-trade fund (ETF) traded on the SPCI.
Fichtel believes the new index will actually encourage investment in commodities, and S&P argues that pension fund managers could benefit from viewing commodities as investment classes.
Melinda Chu said commodity linked investments were gaining acceptance as an alternative investment in the traditional equity/bond asset allocation. Because of the uncorrelated nature of this asset class against both equities and bonds, there were significant diversification benefits to be derived from a commodity investment, she says.
“Commodities are also considered to be an excellent hedge against the risk of inflation. Studies also show that historically, commodities have tended to outperform when bonds underperform. In the calendar years 1994 and 2000, Commodities have by far outperformed both equities and bonds - thus proving that pension funds who had a small commodity exposure during this time would have hedged out their equity/bond losses,” says Chu.