The Anatomy of Commodity Indices
Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index.
This is where the concept of index is derived from. It provides a pulse of the market wherein one can find out about the underlying health by having a mere look at it.
Commodities have traditionally been pretty difficult to track. The number of commodities which are traded is huge and they are pretty diverse as well. However, of late several indices have been created to track the health of the commodities markets as well.
Another major advantage of these indexes is that it gives the buyers opportunities of diversification. Instead of buying units in different underlying commodities, the buyers can simply buy a share in the index and as a result will indirectly own a portfolio comprised of several entities for as little as a few dollars!
However, when we look at the performance of these indices, they vary widely from each other. This confuses a lot of investors. However, this variation is because of inherent differences in which the way in which these indices absorb market movements. In this article, we will have a closer look at these indices.
How the Components are Selected ?
Stock market indices are usually composed of the 20 or 30 largest companies by market capitalization. It is therefore easy to see which company will be listed and which will not be.
However, commodities are quite different! Here, different indices have a choice regarding which commodities they want to include in their index and which they want to omit. The subjectivity involved is much more in case of commodities.
For instance consider the case of S&P indices. These indices include or exclude commodities based on their production value. On the other hand, some indices include commodities based on their representational value. For instance gold is considered to be a representation of the metals market whereas oil is considered to represent energy.
It is for this reason the commodities included in one particular index can vary widely from the commodities included in another index. So, the effect of change in price in commodities will impact different indices differently.
The direction of the movement may be same but the magnitude may be different. For instance, an underlying movement in one index may cause a 3% movement in one index but a 5% movement in another.
How Weighted Average is Decided ?
What weights should be assigned to which commodity in an index is also a grey area. One possible method is to assign weights to the commodities based on their production volume. The commodity which has the highest production will therefore have the highest influence as well. But then another question arises! The production of commodities is a dynamic thing which keeps on changing.
So, should the weights given to the commodities keep on changing as well! Some indices fix these weights for a pre-determined period of time. However, other indices allow them to float with the changes in production causing even more volatility.
Another possible method is to assign weights based on the liquidity that these commodities have. The number of futures contract outstanding in the market is considered to be a reliable measure of liquidity.
Some indices assign weights based on production whereas others do so based on liquidity. As a result, the indices will be formulated differently and will reflect the price changes differently as well!
Roll Over Yields
Commodity contracts are only used for monetary settlement. Very rarely does anybody take delivery of the underlying. Hence, contracts are usually rolled over to another month.
However, there is a price difference present when contracts are rolled on to a future month. This difference between the current months price and the forward months price is called a roll over yield.
Different indices account for this yield differently. Since these yields can have a significant impact on any investments performance, the difference in accounting creates difference in portfolio performance as well.
Lastly, these terms and conditions used by commodities exchanges are not fixed. They too keep changing with time. The frequency with which this rebalancing is done also has an impact on the index value.
As a thumb rule, investors usually prefer indices which have stable policies. This is because when policies are changed too quickly, the values do not remain comparable. Hence, conducting any sort of historical analysis for decision making becomes a difficult task.
It is therefore advisable that investors choose their index first and then later follow it. It would be unwise to switch between Dow Jones, S&P or Jefferies every now and then as the numbers will simply not be comparable!
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