Commodity indexes getting more complex

Commodity indexes getting more complex

Collins, Daniel P

While passive investment dollars are still flowing to funds benchmarked to long-only commodity indexes, a little more care is being taken as per the weighting of those dollars.

The explosive growth that marked the long commodity index sector of recent years continues, but new money is looking to take advantage of sectors that have lagged the overall commodity growth, particularly agricultural commodities.

The Goldman Sachs Commodity Index (S&P GSCl), which recently was sold to indexer Standard and Poor’s, has long been criticized for its energy focus (see: “S&P GSCI breakdown,” right).

While the bull markets in crude oil and natural gas helped propel the performance of funds benchmarked to the index, the contango condition of those markets placed a tax on its performance and the heavy weighting in energy muted the performance of other sectors and made it vulnerable to corrections in the energy sector.

This is what happened in 2006 as the GSCI dropped 15.09%, which was only it’s second down year since 1999. Other commodity indexes suffered poor relative performance but outperformed GSCI due to a lower exposure to energy.

While there is evidence the commodity bull market is alive and well, with many of the supply/ demand imbalances that spurred the bull market still to be worked out, many sectors have grown exponentially and there is less opportunity for growth in those sectors.

Whereas a couple of years ago the strategy was simple – diversify your stock and bond portfolio with a broad index of commodities today indexes are offering a smorgasbord of products with varying weightings in multiple sectors.

Tom Price, president and CEO of Beeland Management, the general partner of the Roger’s Raw Materials funds, estimates that one third of new money coming into funds benchmarked to the Rogers International Commodity Index (RlCl) are going into sub indexes. RlCl splits out the metals, ags and energies into separate sub indexes. Price says eventually one-half of new money and one-third of total funds will be allocated to the sub indexes.


The growth of funds benchmarked to commodity indexes is not simply a story of one investment strategy but of many. For a time these index positions’ effect on the market was so consistent and so predictable, traders saw it as free money. That was until last fall in the wheat market when a supply disruption in Australia caused sharp reversals in wheat spreads.

As the size of commodity funds grew, hedgers and speculators noticed that effect on the spread relationships of various markets as huge positions were rolled at predetermined times as directed by the prospectuses of the indexes. Market participants demanded and received a breakout of these traders’ positions in the Commodity Futures Trading Commission’s Commitment of Traders report. Trading strategies were created to exploit the money flows of funds benchmarked to these indexes.

Hilary Till, editor of the recently released book, Intelligent Commodity Investing, points out that while these indexes definitely are a new fundamental in the market, they are not the only fundamental. Traders seeking to exploit the money flows learned this the hard way last October.

“[You have] to keep in mind if you are looking at index pressure that there are real underlying physical markets,” Till says. “So if you have a severe weather event impacting wheat, a bear calendar spread may not be a great idea.”

You can have trades that are consistent, consistent, consistent, without understanding all the underlying factors. So you are so confident because the trade “always works” that is the time to start putting on size. Well there can be a mean reverting affect. Other people can have noticed the trade or it could have gotten to the point where a trade for fundamental reasons is not seasonally favored. So you have levered into this previously wining trade and then lose a year or two worth of P&L.”

This apparently is what happened with many wheat locals last fall, as certain calendar wheat spreads moved as much as $1 in a week. Several market observers compare the use of bear spreads this way to an options writing strategy, which can offer consistent profits until one huge spike in volatility can wipe out months of profit and more.

Just as traders developed these strategies as they saw the effect of money flows on the underlying market due to the growth of long commodity indexes, they are continually analyzing these money flows to find opportunities.

VanKar Trading Corp. Principal Emil van Essen has created a strategy, the Emil van Essen Spread Trading Program, that enters bear spreads earlier in the process in an attempt to exploit not the actual Goldman roll, but all the positions placed in front of the roll.

“The program is based on getting in front of the flow of money involved in the long-only funds, particularly from locals and managers who are trying to front run the Goldman roll,” van Essen says. He’s developed a complex algorithm that measures the flow of money. The fund usually takes profits prior to the actual Goldman roll. “We realize that there is a lot of movement of money and we try to measure it.”


Obviously the problem for the indexer is a different one. With their rules out in the public for all to see, when will the contango situation in certain markets and the large number of positions being placed in front of their roll periods begin to adversely affect their performance, if it hasn’t already?

As mentioned before, one thing indexers are doing is breaking up their indexes into sub sectors, which allows people to weight their investments in a way to take advantage of sectors with more potential. S&P GSCI’s Reduced Energy, Light Energy and Ultra Light sub indexes track the performance of commodity markets using the same conventions as the main index but with a lower weighting to energy. They also have created a non energy index (see “Variety Pack,” page 59).

Creating sub index products allows for more flexibility. Price points out that Jim Rogers, the creator of the RICI, noted six months ago that there was greater potential in the ag sector, particularly grains.

While the ability to invest in long only products with different weightings allows investors to avoid getting caught in large sector corrections, it does not address the contango issue or the potential problem of large amounts of money front running their roll. The RICI index committee this past spring adjusted its roll rules by a couple of days.

While the adjustment was not major, Price, who sits on the RICI Index committee, says they are constantly examining the market environment and will make changes as necessary. “We sometimes feel we need to make changes. Things like that are always under review,” Price says, but adds, “It is one thing to change your roll time, it is another thing when you change your structure.”

While some major indexers have denied any connection between the indexes and the current contango, Price does not. “If the funds didn’t get this big, we wouldn’t have gone contango in the energy markets,” he says, adding that indexers may need to be proactive in the future.

“For a long time you had backwardation and attribution tables clearly that showed backwardation was a great part of the yield. All of a sudden we’re in contango,” Price says. “Is it going to reverse itself back or are the long only index funds going to keep it that way for a long time? If it is going to keep it that way for a long time you are going to have to make some adjustments.”

Several have already begun to do so. Michael Lewis, in his chapter in Intelligent Commodity investing, writes, “The traditional approach to rolling commodity index futures on a predefined monthly schedule is in need of reform to address the implications that unstable term structures imply for the roll return within a commodity index.”

Lewis, who works at Deutsche Bank, goes on to describe the Deutsche Bank Liquid Commodity Index – Optimum Yield (DBLCI-OY). The index does not roll monthly but rather to the futures contract – deliverable in the following 13 months – that generates the maximum implied yield. Lewis writes, “The BDLCl-OY index aims to maximize the potential roll benefits in backwardated markets and minimize the roll return cost associated with contangoed markets.”

The DBS Bloomberg Constant Maturity Commodity Index (CMCI) was launched in January. The CMCI uses a range of different maturities for each of the 28 commodities in the index. UBS claims that the limitation to front month futures contracts by indexes has been responsible for deterioration in returns. CMCI attempts to offset the negative affects of contango.

Michael Magers of Barclays Global Advisors writes in a separate chapter in Intelligent Commodity investing, “As commodity indexes mature as an asset class, investors will seek managers who can compliment beta exposure with skill in trading the underlying components to add incremental outperformance.”

Those managers are out there. Quality Capital Management’s Enhanced Alpha Program has returned 82% since inception in April 2005. The program is a long-only product designed to give commodity beta, but can generate alpha through its proprietary allocation algorithm that dynamically shifts resources between assets and strategies to weigh those markets that look relatively more attractive.

The idea of producing beta returns without being tied to an index with published rules is not a new one. Gresham Investment Management’s Tangible Asset Program was launched in 1987 by industry legend Henry Jarecki (see “Commodities make the right mix,” February 2007). The TAP program invests in a diversified group of commodities similarly to funds benchmarked to the major indexes but, because it does not have published rules, can roll those futures contracts at more optimal times. Gresham estimates that TAP has outperformed the S&P GSCI by 3% per year, 67% of total outperformance, can be attributed to its ability to avoid roll congestion.

Whether all of the indexes eventually change their procedures will ultimately depend on performance.

“You just can’t sit back and show bad performance because you don’t change your rules,” Price says. “In the free market system, competition does wonders. Everybody is going to evolve to the best marketing and execution procedures to have the least amount of negative impact from either backwardation or contango issues. You have to recognize that there is an awful lot of money tracking that stuff and the money is not going to sit around and say, ‘well let’s get beat up again next month.'”

The story of the long-only commodity indexes is similar to the onset of other strategies. They have spotted an opportunity and exploited it and have grown to where they are a factor on the markets.

Till warns that while understanding these indexes is important, there have been a number of structural breaks in relative value relationships within the commodity sector in recent years and the funds are not responsible for all of them. “Understanding the various fundamentals in the marketplace is key. Indexes are part of the story part of the story,” Till adds.

Price says there will be a number of changes in the various indexes and funds that track them. “The next basic evolution will he to look at the contango versus backwardation issue. Everybody in our business is very much aware of all the issues because it affects performance. The ones that will survive will be the ones that have the ability to adapt and to make the necessary changes, just as traders have over the years.”

Price also says the RICI will survive. “As the field gets more populated you’ve got more competition and competition is the thing that drives change. If you can’t change and be more competitive than the next guy then you will end up with a model T.

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Copyright Futures Magazine Group Jul 2007

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