At least, I am open to the idea in the commodities market. And you should be too. Because there's no guarantee that indexing is the "right" strategy for commodities (the way there is with stocks), and there's considerable research showing that a momentum-based strategy might work.

The Problem With Indexing Commodities

The case for index funds in the stock market is absolute. It's a mathematical certainty that the average low-cost equity index fund will outperform the average high-cost active fund over time. There are also reams of literature supporting this claim on an empirical basis.

But in commodities, that's simply not the case. Remember: There is no "commodities market" in the way there is a "stock market." And there's no literature that I'm aware of showing that commodity indexes offer the best approach for investors.

Consider that the two most popular commodity indexes in the world—the S&P GSCI and the DJ-AIG—differ wildly in their makeup and performance. The S&P GSCI is 70% Energy, while the DJ-AIG is just 31% Energy. The S&P GSCI is 3% Precious Metals, while the DJ-AIG is 12% Precious Metals. As a result, the S&P is down 52% over the past six months, while the DJ-AIG is down just 42%.

If you're claiming that "pure indexing" is the "right" solution for commodities, which index are you going to choose?

The Persistence Of Momentum In Commodities

What's more important than the issue of creating the "right index" is that there are structural differences in the commodities markets that have a direct impact on market performance. The hedging needs of farmers and industrial producers, storage costs, the growing cycle for agricultural products and many other factors have a long-term impact on returns.

In stocks, active management doesn't work because stock-picking is a zero-sum game: for every winner, there's a loser. But in commodities, that's not true. There are players in the commodities market that aren't investors, and that introduces a whole array of new possibilities.

An increasing array of academic studies suggests that the existence of these noninvestors (and the existence of extra-market trends like storage limits, seasonal/natural cycles, etc.) gives rise to persistent and exploitable momentum trends in the commodities markets (see, for example, Erb and Harvey (2006) or Schneeweis, Kazemi and Spurgin, (working paper, 2007) or Gorton, Hayashi and Rouwenhorst (2007)). In each case, the authors show that a simple momentum strategy applied to commodity futures can create strong returns.

Most studies also show that simply going long backwardated commodities and short commodities that are trading in contango is a decent strategy, although it doesn't work perfectly.

You have to remember: commodity index investing is relatively new. It's really only been in the past few years that institutions and academic researchers have focused their attention on it. 

There is a huge amount of very, very interesting research going on right now on the best way to structure a commodity index. While a naive long/short strategy might not be the best bet, it is worth considering. Down the road, there is likely room for strategies that simply over- and underweight different commodities, or push the field in other ways. I find all of that interesting, in light of the emerging academic literature in the space.

Does that make me a market-timer? I don't know. I think it just makes me open-minded.