Commodity Index Due Diligence

Commodities in the absence of Contagion, can help diversify a traditional portfolio, through the exposure to different return drivers. Commodities has however gone through rapid development since the first generation GSCI types was launched. With this Group i hope we can have a constructive dialog around good Commodity indexing and Strategies, improving both our knowledge and performance.

Commodity Indices

Broad based commodity indices can serve many purposes in a modern investment portfolio. In the resent run up of commodity prices, investors as increasingly seen them as a source of diversification in their Performance Portfolio. By combining commodity indices with traditional assets, investors may be able to obtain higher risk-adjusted returns for portfolios. Historically commodities has tended to have little, or even negative correlation to other asset classes, while average historical annual returns for most indices have exceeded 10% during the past 15 years.

Commodities tend to be little correlated with other asset classes because the factors driving commodity prices are fundamentally different. Equity and bonds are anticipatory assets priced by expectations of future gains or cash flows while commodities are driven by supply and demand fundamentals prices adjust in order for the spot market to balance. However, whenever the micro fundamentals give away to macroeconomic factors as the main driver of price movements, we should expect cross asset correlations to rise. In general, high correlations are bad news for active managers. In a world of high cross-asset correlations, insight on specific markets becomes less valuable and actively managed vehicles that depend on these insights are likely to be less profitable.

Since investors ultimately care about the real purchasing power of their portfolios, protection against inflation is one of the main considerations for long-term investors. Commodities are directly linked to the components of inflation, as they are an important part of the production process of many goods. Therefore commodity investment can also can work as a good vehicle for inflation hedging in a Liability Hedge Portfolio. Sensitivity to inflation rates varies across the different commodities with energy related commodities being among the most sensitive to inflationary shocks. Perhaps we will one day see a Total Return variant of a commodity index strategu collaterized with TIPS.

While commodity prices benefit from high inflation, fixed-income investments suffer from it, especially when high inflation is accompanied by an interest rate hike central banks standard response to high inflation rates. Because of this reverse relationship to inflation, commodities show strong negative correlation with fixed-income investments over the long-run.

Also, since unexpected inflation shocks are often associated with negative shocks to the economy, the hedge provided by commodities may come into play at times when it is most needed.

Incorporating a smaller allocation of commodity exposure into a Extreme Risk Hedge Portfolio together with fx. VIX futures exposure may work as a hedge mechanism against sharp falls in the equities market. Because of this a third group of investors utilize especially Energy based indices in their Extreme Risk Hedge portfolios, due to historically Convex hedge properties of such, during extreme events. 

Total return commodity indices offer investors three sources of returns:

A. Spot returns, generated by the increase/decrease in prices of the underlying commodity futures.

B. Roll returns, generated from the rolling of nearby futures into longer-dated futures

C. T-bill returns, typically added to the index in order to make it a fully collateralized investment.

When commodity prices increase they generate positive spot returns and vice versa, but positive or negative roll returns also have a direct impact on index performance. Because of roll and T-bill returns, a total return commodity index may yield positive returns even when commodity prices are declining. Similarly, a negative roll yield could result in negative commodity returns even if commodity prices go up.

Spot returns are a function of movement in the underlying commodity prices, hence selecting the right commodities is ofcause very important to index performance. 

Investors have traditionally gained exposure to commodity markets via futures contracts or products linked to futures contracts. This avoids the impracticalities of holding and storing the underlying physical asset. When a futures contract approaches its expiry, investors holding the futures contract must roll their position in the current futures contract into a futures contract with expiry further in the future. If the prices of the futures contracts are not the same at the time of the roll, the position will be rolled into futures contracts representing a different amount of the underlying physical commodity. Over time, this roll process increases or decreases the number of futures contracts the investor is exposed to and, relative to the spot price, may create an additional source of gains or losses. Thus, an investor holding a commodity investment based on futures contracts may experience either a profit or a loss due to the roll process even if the spot price of the commodity has remained unchanged.

The gain or loss generated by holding and rolling the futures contract is known as the roll yield and can have significant impact on an investor’s total return. Futures markets that generate negative roll yield are said to be in “contango” and futures markets that generate positive roll yield are said to be in “backwardation”.

Also in cases where investors does not hold the commodity physically, but instead invest in commodities through futures. What happens in spot markets is important but the storage market is also important because it interacts with the spot market and influences the slope of the futures price curve, which is the source of roll yield.

Roll returns are also heavily influenced by both the underlying selection of commodities and their corresponding futures term structures, as well as by the rolling mechanics applied by each commodity index. The way contracts are rolled directly affects the index overall performance. Because of its very nature, the roll return is also uncorrelated to other asset classes. 

One way to calculate roll yield is to take the difference between the return of the Spot Index, which represents the static prices of the next-to-delivery futures contracts, and the return of the Excess Return Index, which takes into account the impact of rolling forward futures contracts.

The interest earned over the investment set as collateral provides another positive return cushion, even when commodity prices are declining. 

There are many commodity indices on the market, and each index is constructed using a particular methodology and tracks the price movement of a particular basket of commodity futures contracts.

The RICI has the largest basket of commodity futures (35), and the DBLCI the smallest basket (6). Broadly speaking, including a large number of commodities has the advantage of making the index less sensitive to a particular commodity or a commodity sub-sector. The marginal benefit of including more commodities in the index declines as more commodities are added.

Asset Selection

A combination of selection criteria determines which and how a commodity futures contract enters a commodity index. Usually on 1St. Generation Broad Based Commodity indices, selection criteria could be liquidity and volume, location of the commodity exchange or the currency of the commodity contracts. In 2nd. Generation indices we are in addition seeing Screening Strategies around optimizing Roll Yield or taking positions only into Commodities exhibiting Momentum.

Asset Weighting

For each index, the weights at which these commodity contracts are aggregated are calculated in a different way, creating an important source of differentiation. In the case of the MLCX, index weights depend on world production in order to provide an accurate account of the weight of each commodity in the world economy. Other indices, such as the SPCI-G, rely entirely on the liquidity of the underlying contracts. The GSCI and DJ-UBS use a combination of both production and liquidity to determine weights.

Allocating a large weight to a small sub-set of commodities can bias index returns to particular sub-sectors, introducing risk and volatility. The GSCI, for instance, has a large energy concentration, in particular to WTI crude oil. In order to spread out risk across different commodity sectors, other indices, such as the MLCX, the SPCI or the DJ-UBS, establish caps and floors on the share of any particular commodity sub-sector.

Double-counting

For a related reason, these indices also avoid implicitly double-counting commodities that are used as an input in the production process of other commodities. The MLCX, for instance, adjusts weights of upstream commodities, such as crude oil, in order to give a proportionally higher weight to its downstream commodities, such as gasoline or heating oil. Other indices like GSCI does not adjust for double counting. 

Roll schedule & Window

Index performance hinges to a large extent on the underlying mechanics used to roll commodity futures forward as they approach expiry. The major indices vary greatly on the way they roll commodity contracts forwards. Although the first nearby contracts are generally the most liquid, based on open interest, they may also become the most expensive (resulting in lower total returns) when the commodities market is in contango (when further out future contracts trade at a premium). Conversely, when commodity markets are in backwardation (when further out future contracts trade at a discount), indices that employ a near month Roll strategy generally boast higher total returns. The negative impact of contango on total returns is a source of frustration to commodities investors who sometimes see the spot prices going up while their commodities investments lag significantly behind.

Even within the same index, contracts can have different roll schedules due to liquidity and/or seasonality of the underlying commodity.

While using longer maturity contracts tends to greatly increase roll returns, it does not affect spot returns significantly. Thus, rolling to contracts that are still liquid but further out on the forward curve tends to increase total returns. In addition to increasing total returns, investing in longer maturity contracts can also reduce the variance of index returns, effectively enhancing risk-adjusted returns. 

Enhancing Roll Methodology

There are a number of dynamic roll index choices currently available in the marketplace, all of which represent attempts to mitigate the effects of contango and curtail the costs of replication. They can be categorized into four basic strategies:

1. Liquidity Enhanced Roll Strategy

When employing an Enhanced Roll strategy, a specific contract month is chosen for its liquidity characteristics used for a whole year. For example, in November 2009, the investor may roll into the December 2010 contract which has an expiration date twelve months ahead, thereby going further out onto the futures curve, and avoiding all monthly rolls until November 2010. While this strategy substantially reduces the costs of replication, it also commits to the same contract for a long period of time, during which the market may undergo significant changes. (The S&P GSCI Enhanced Index employs this strategy.)

2. Forward Roll Strategy

This approach takes the roll schedule from the Standard Roll framework and places all the contracts farther out on the futures curve, depending on the number of months left to go forward on the curve (one month, three months, six months, etc.). Since the Forward Roll strategy is carried out each month, it may not diminish the costs of replication. (The S&P GSCI 3-Month Forward Index employs this strategy.)

3. Constant Maturity Strategy

Instead of investing in a single futures contract, the Constant Maturity strategy spreads the long futures position over a number of contract months along the futures curve. It can be spread equally over each of the six active contracts, or it can be spread over designated intervals (for example, the three-month, six-month, one-year, two-year and three-year constant maturities). (The UBS Bloomberg Constant Maturity Commodity Index (CMCI), BNP Paribas Commodity Market Representative Index (CMRI) and JP Morgan Commodity Curve Index (JPM CCI) employ this strategy.)

4. Implied Roll Yield Strategy

This approach determines the Implied Roll Yields among the contracts out to a particular maturity, and chooses the contract that has the maximum Implied Roll Yield, where the Implied Roll Yield is defined as the basis of the contract. There are two variations on this approach: i) the basis can be based on the front futures contract for all the contracts, or ii) the basis can be based on the two consecutive futures contracts. In both cases, the Implied Roll Yields would have to be adjusted for the time difference between the expiration dates of the respective contracts. An example of an index that employs this approach is the Deutsche Bank Liquid Commodity Index – Optimum Yield Index, where the basis is referenced from the front futures contract. Another example is the Diapason Commodity Index – DCI BNP Paribas Enhanced, where the basis is based on consecutive futures contracts.

Roll window is also important for commodity roll-returns

Any Commodity index has a contract roll mechanism, as futures contracts expire and have to be rolled forward to avoid physical delivery of the underlying commodity. Indices with wider roll windows are able to smooth out the risk of facing adverse trading circumstances. There is evidence that rolling during the window utilized by some of the major commodity indices, namely the 5th through 10th business day of the month, tends to erode roll returns, particularly in the energy markets. Therefore spreading the buying and selling process over a longer period reduces the pressure to sell contracts in a quick burst and prevents dis-advantageous trading circumstances from eroding roll returns.