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How They Stack Up
Figure 4 shows the general performance statistics of the Morningstar Long/Flat, Long-Only and Long/Short Indexes from January 1991 through March 2008, compared with other indexes. (For the sake of simplicity and clarity, we focus our discussion of results on these three indexes.)
Generally, the Morningstar Commodity Indexes' return and risk characteristics rank favorably relative to other benchmarks. Note, for example, the Morningstar Long/Short Index's better return and moderate risk compared with the S&P GSCI and Dow Jones-AIG indexes.
The diversification characteristics of the Morningstar Commodity Indexes can be seen in Figure 3, which shows a correlation matrix for January 1991 through March 2008.
Lastly, we look at the sector exposures for each index through time. Figure 5 displays the sector weights of the Morningstar Long-Only Index at the annual reconstitution dates over the entire back history of the index, starting in December 1979. Note how the sector representation changes in relation to the sector's relative importance in the commodity futures markets, but within limits so as to maintain diversification. Specifically, at the most recent reconstitution, Energy represented about 39 percent of the index and Metals nearly 14 percent, whereas in the early 1980s, Energy contributed a very small proportion while Metals as a group formed about 18 percent of the index.
 
Downside Protection
While all long-only commodity indexes tend to provide strong protection when the stock market is down and in inflationary environments, the Morningstar Long/Short Index does a much better job by limiting downside risk while negotiating ups and downs in the commodity markets themselves. The Morningstar Long/Short Index's maximum drawdown in the 1991-2007 period was less than one-third that of the DJ-AIG Index and less than one-quarter that of the S&P GSCI. We also compared maximum drawdowns experienced by the listed indexes during five-year subperiods within that overall period, and the Morningstar Long/Short Index suffered much smaller drawdowns in all subperiods. Clearly, a long-short strategy is better able to tap into the underlying momentum of commodity prices, thereby limiting losses in down markets.
The Long And Short Of It
The long-only strategies that currently dominate the commodity index market do not best serve investors as investment vehicles or as benchmarks. Since futures price changes and roll yields are the sources of excess return, long-only indexes have no way to capture the returns available from shorting futures when there is downward price pressure or a positively sloped futures price curve. Long-only indexes generate negative roll yields when markets are in contango (when distant-delivery prices exceed near-delivery prices) and thus can have negative returns when commodity prices are rising. Furthermore, since many actively managed CTAs invest in long and short futures based on momentum trading rules, the long-only indexes are not appropriate benchmarks, rendering traditional approaches to representing beta exposure unsuitable.
By using a momentum-based approach that takes into account both price change and the slope of the futures price curve, these new Morningstar indexes aim to maximize both sources of excess return—price change and roll yield—to produce better performance. In addition, these indexes are logically consistent with the underlying economics of commodities futures markets, and backtested results show an attractive risk profile, low downside risk and low correlations both to traditional asset classes and long-only commodity indexes. As passive investment alternatives, these rules-based indexes could offer easier access to actively managed commodities trading strategies.
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