Commodity prices and the level of investment in commodities strategies have risen significantly in the last few years. With more investors focusing on commodities, more money is expected to pour into commodity indexes through exchange-traded products, mutual funds and futures. Commodity-index-linked investment vehicles now command approximately $185 billion, and this trend seems unlikely to abate.

However, there is reason to question how well investors are being served by the traditional long-only commodity indexes as either benchmarks or proxies for investment products.

Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the commodities "asset class." While we do not offer an approach to taking pure beta exposures in this study, we assert that new passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity indexes are better benchmarks for active strategies.

For many asset classes, it is easy to take a pure beta exposure—multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500 and Dow Jones Wilshire 5000 indexes, for example, are representative of the broad stock market and have similar performance characteristics, just as the Citigroup Broad Investment-Grade (BIG), Lehman Brothers U.S. Aggregate and Merrill Lynch U.S. Domestic Master bond indexes mirror the wider fixed-income market and perform alike. Yet for commodities, fewer choices and more disparity exist among the index options.

Not All Indexes Are Alike
Figure 1 illustrates the similar risk and return characteristics of the broad stock and bond indexes and the disparity among the three traditional commodity indexes—the S&P GSCI Total Return Index, the Dow Jones-AIG Commodity Index and the Reuters/Jefferies CRB Index. When we plot standard deviation and compound annual return for each index over a common time period (January 1991 through March 2008), we see that the nearly identical risk and return characteristics of both the stock and bond indexes place the plot points on top of one another. The commodity indexes, however, do not display the same level of consistency. Dramatic differences in constituents and weighting schemes as well as rebalancing rules are likely the cause of the performance differences in the commodities indexes. The S&P GSCI, for example, has about double the weighting to the energy sector as the Dow Jones-AIG and the Reuters/Jefferies indexes and only one-third of the weighting to agriculture.

Sources Of Excess Return
Long-only commodity futures strategies can prove inadequate in providing investment exposure to commodities, which is why professional commodity trading advisors (CTAs) tend to take both long and short positions in commodity futures, often based on trends in prices.

A futures strategy generates excess return (i.e., return in excess of the risk-free rate) from two sources:

• Changes in futures prices
• The roll yield—which can be either positive or negative—that results from replacing an expiring contract with a further-out contract in order to avoid physical delivery yet maintain positions in the futures markets

A complete understanding of these two sources of return requires an analysis of three interrelated markets for each commodity:

• The spot market—the cash market for the commodity itself
• The futures market—the market for contracts to deliver the commodity in the future for a price set today
• The storage market—the market for the service of storing the commodity on behalf of its owner

What happens in spot markets is important to futures investors because changes in spot prices impact futures prices. The storage market is important because it interacts with the spot market and influences the slope of the futures price curve, which is the source of roll yield. Next we discuss how the spot and futures markets influence price changes and how the storage market impacts the slope of the futures price curve and hence the roll yield.

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