Commodity indices and the January rebalancing

Investors in commodities have experienced another difficult year in 2012, as performance in the three main sectors - metals, energy and agriculture - have varied greatly. In the following overview, we take a look at the most popular ways of tracking commodity performance and the potential impact, if any, of the January rebalancing. 

Taking a look at the sector performance of two of the world’s most followed commodity indices - the Dow Jones UBS CI index and the S&P GSCI index – reveals that overall return so far this year is just around zero. This is a weak performance if we compare it with the 14 percent return on the S&P Index or the 14.5 percent return on the MSCI World index during the same time.

What is a commodity index?
Before moving on, let us just have a look at what a commodity index actually is and how it works. A commodity index either invests in or tracks the performance of a group of commodities based on predefined rules. It is often the performance of these indices that is referred to in the media or when comparing commodity performance with other markets, such as stocks and bonds. Large investors often prefer a diversified approach, especially to commodities, given the high level of volatility that invariably goes with investing in individual commodities. Commodity index funds help investors to properly benchmark the performance and return of their investments. Due to the increased popularity of commodities these funds have grown in recent years. 

Two major indices
The two major indices, as mentioned above - the S&P GSCI index and the DJ-UBSCI index - have become the industry-standard benchmarks for investors in commodities. These two indices have a large investor following, with billions of dollars having been invested either directly into the funds or through exchange traded funds, which track their performance. Furthermore, many local commodity fund offerings track one of the two commodity funds. 

Different structure and strategy
The S&P GSCI, established in 1991, is an index calculated primarily on a world production weighted basis and it comprises 24 physical commodities that are the subject of active, liquid futures markets. The weight of each commodity in this index is determined by the average quantity of production and is designed to reflect the relative significance of each of the included commodities in the world economy. Due to this structure the S&P GSCI is very heavily exposed towards the energy sector, with 70 percent of the index currently invested in products ranging from crude oil to natural gas.

The DJ-UBSCI, established in 1998, has a more diversified approach. This index comprises 22 physical commodities, all represented by an active futures market.  No single commodity can comprise less than 2 percent or more than 15 percent of the index and no group or sector can represent more than 33 percent of the index. The weightings for each commodity included are calculated in accordance with rules designed to ensure that the relative proportion of each of the underlying individual commodities reflects its global economic significance and market liquidity. 

Different composition - different performance
The different structure of the two indices helps to explain their different performances, as seen below. The energy sector, for example, has had the greatest impact on the performance of the GSCI index. This was particularly clear during the first half of 2012, when geo-political concerns related to Iran’s nuclear intentions sent oil higher before collapsing by 30 percent. From June and into August the main focus was on the key crops, such as corn, wheat and soybeans, as drought hit large areas of the US, Russia and Ukraine. This helped the DJ-UBS to outperform given its higher allocation to grains and into Q4 this outperformance continued as industrial metals became the main focus. 

Investors looking for passively managed exposure should therefore be aware of these differences. One could either go for a primary exposure to energy through the S&P GSCI or the more broad based approach being offered by the DJ UBS index. There are of course numerous other commodity indices which also can be traded through Exchange Traded Funds, of which the best known are probably the Reuters-Jeffries CRB Index and the Rogers International Commodity index.

Impacts of the January rebalancing
Index-linked commodity investments such as the ones that follow the major commodity indices mentioned go through a rebalancing period every year where the index weightings are adjusted. The reason for this process is to align and adjust existing positions according to the individual performances during the previous year. Generally, the exercise involves buying/increasing the exposure of commodities which suffered losses during the previous year at the expense of selling/reducing commodities experiencing gains. In addition, the overall target weight of an individual commodity or sector can also be adjusted, while old contracts can be removed or new added. The rebalancing for both commodity indices occurs in January during a five-day business period from January 8 to January 14. 

DJ-UBS will next year include soybean meal and KCBT wheat which in both cases will result in some selling of CBOT wheat and soybeans in order to make room for the new entrants, while at the same time maintaining an unchanged exposure to the grains and oilseeds sector. The biggest change, however, is the decision by S&P GSCI to further increase the exposure to Brent Crude Oil at the expense of WTI Crude Oil as it continues to lose importance on the global energy scene. Although WTI still carries the highest weight, it will nevertheless see a 6.25 percent reduction to 24.71 percent, while Brent will get a 3.99 percent increase to 22.34 percent.

It is estimated that between USD 80 and 100 billion is invested in products tracking the S&P GSCI and the change in the two oil weightings could, according to ETF Securities, result in a USD 4.5 billion move out of WTI and USD 5 billion move into Brent. Although these are big numbers, they both represent less than two percent of the total average daily trading volumes and as such should be easily digested by the market. Another reason for expecting no major impact is the fact that these changes have been announced well in advance and while they could make a short-term impact on time spreads no permanent impact on spot prices should be seen as these transactions do not create any additional physical supply/demand.