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Component Selection And Weighting Methods Of Commodities Indexes
The commodities markets are among the most liquid, highly developed and strongly regulated markets in the world, with balanced participation of buyers and sellers. The commodities markets represent one of the most appropriate environments to apply an index application within the alternative investment universe. The question is, How best to capture commodities market beta for investors?
Rather than being just one asset class, raw materials could be more accurately viewed as multiple asset classes broadly categorized in sectors as energy, metals, grains, softs, etc. The components of each category often correlate to one another but may not correlate to the other categories or components. It stands to reason that commodities indexes that have relatively high or low exposures to any particular sector/component would vary meaningfully from other commodities indexes in certain periods. However, the well-known commodities indexes do correlate highly to one another, and this is strong evidence that they provide "asset class exposure." For the most part, commodities indexers attempt to include the most "important" commodities, but they often disagree about how many to include and how much of each.
Commodities indexes generally have governing committees that implement the component selection rules and decide which components to include. The primary component selection requirement shared by most commodities indexes is liquidity as measured by open interest. Additional selection criteria beyond liquidity are often more judgmental. We subscribe to the fundamental tenet that an index approach is best applied to highly liquid, "efficient" markets. Therefore, component inclusion screens for volume, open interest and narrow bid/ask spreads are appropriate selection criteria. We agree that additional judgmental factors such as "relevancy" and overall balance objectives are appropriate considerations for commodities index committees. Longview's component and contract month selection process consists of liquidity, volume and open interest screens as well as relevancy and overall balance objectives. This process results in the selection of 16 components across the major sector categories (energy, metals and agriculture). Ultimately, there is considerable component overlap between indexes as to what commodities are most liquid and most important (highlighted in Figure 5). The primary differences come as a result of how many additional components are included and the weightings. (See Figure 5 for recently published weightings targets.)
The Rogers International Commodity Index (the "RICI") is a consumption-weighted index and has historically included the most components—currently 38. While the RICI does include the same core componentry as other commodities indexes, a number of the RICI components—e.g., lumber, rapeseed, adzuki beans and milk—may not meet the liquidity requirements of most commodities indexes. The Deutsche Bank Liquid Commodity Index (the "DBLCI") has historically incorporated the fewest components and, as the name implies, has high liquidity requirements. The S&P GSCI, DBLCI and RICI each have high energy sector allocations relative to the more evenly balanced DJ-UBSCI and Longview Extended Commodity Index and therefore may reasonably be expected to experience periods of over- or underperformance based on that exposure.
If one looks at trends of componentry changes, one will see that the DJ-UBSCI has reduced industrial metals components: Within the past two years, tin, lead and platinum were removed from metals, as was cocoa from the softs sector. While silver and platinum are strictly classified as "precious," both have surprisingly high "industrial" percentage uses of their annual production. The RICI changes inclusion of its more "obscure" components: Within the past year, greasy wool was removed, while rapeseed and milk were added. The DBLCI, when first introduced, included only six components and has significantly increased components over time to 14. The S&P GSCI, DBLCI and RICI tend to have higher energy sector allocations, while the DJ-UBSCI and the LEXTR are most similarly weighted and balanced, with energy sector allocations in the range of 33 to 35 percent. Ultimately, the most meaningful differences between the indexes lie in weightings and roll mechanics.
Equity indexes tend to be weighted by market capitalization, equal weighting or fundamental weighting, but commodities have fundamentally different characteristics that must be considered in the index design and weighting process. In addition to having expiration dates, commodities futures contracts differ from stocks in that they do not have "shares outstanding," which, along with price, is the basis of equity market-cap weighting. However, each commodities futures contract specifies the quantity of each commodity deliverable per contract. These amounts are determined and established by the exchanges and commercial market participants (hedgers) based on what is deemed the commercially suitable and relevant amount, and these have been remarkably stable over time. This then can be used as a proxy to determine a commodity's "market capitalization."
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