{"id":23917,"date":"2021-11-29T08:55:25","date_gmt":"2021-11-29T08:55:25","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=23917"},"modified":"2024-04-11T11:38:20","modified_gmt":"2024-04-11T11:38:20","slug":"construction-of-commodity-indexes","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/construction-of-commodity-indexes\/","title":{"rendered":"Construction of Commodity Indexes"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/udiQ7r5Y7H8\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>Commodity indexes have been created to portray the aggregate movement of commodity prices, investment vehicles, and investment approaches. It can be said that an asset class does not exist without at least one representative index.<\/p>\r\n<p>A commodity index plays the following roles in the commodity sector investments:<\/p>\r\n<ul>\r\n\t<li>It can be used as a benchmark to evaluate broader moves in commodity pricing.<\/li>\r\n\t<li>It can be used as a broad indicator for macroeconomic or forecasting purposes. This can be done by examining statistically significant relationships between movements in the commodity index and other macroeconomic variables.<\/li>\r\n\t<li>It can act as the basis for an investment vehicle or contract providing the information needed to record, monitor, and evaluate price changes that affect contract value.<\/li>\r\n<\/ul>\r\n<p>The following are key characteristics that differentiate each of these indexes:<\/p>\r\n<ul>\r\n\t<li>The breadth of coverage, i.e., the number of commodities and sectors included in each index, considering that some commodities have multiple reference contracts.<\/li>\r\n\t<li>The relative weightings assigned to each component or commodity and the related methodology for how the weights are determined.<\/li>\r\n\t<li>The rolling methodology for determining how those contracts that are about to expire are rolled over into future months. This decision has a direct impact on the roll return (or yield) of the overall commodity. The roll return is one of the three key components of overall commodity returns.<\/li>\r\n\t<li>The methodology and frequency for rebalancing the weights of the individual commodities, sectors, and contracts in the index to maintain the relative weightings assigned to each investment.<\/li>\r\n\t<li>Governance of indexes is important because it is the process by which all the rules, as mentioned above, are implemented. The rule-based indexes follow a quantitative methodology, whereas selection-based indexes are more qualitative in that an index committee picks the commodities. It also ensures that the asset price is independent of the index provider, which, in turn, should be independent of the product provider (e.g., the exchange-traded fund or swap provider).<\/li>\r\n<\/ul>\r\n<h2><strong>S&amp;P GSCI<\/strong><\/h2>\r\n<p>It is the oldest of the selected commodity indexes. It is based on 24 commodities that apply liquidity screens to include only those contracts with an established minimum level of trading volume and available historical pricing. S&amp;P GSCI uses a world production value-weighting scheme that gives the largest weight to the most valuable commodity. It does this based on physical trade value, similar to a market-capitalization-weighted index of nearly all major bond and stock market indexes.<\/p>\r\n<p>It uses the rolling methodology that focuses on owning the front (i.e., near-term) contracts to address the highest liquidity and where supply and demand shocks are most likely to impact.<\/p>\r\n<h2><strong>Bloomberg Commodity Index<\/strong><\/h2>\r\n<p>Commonly referred to as BCOM (previously the Dow Jones\u2013UBS Commodity Index, i.e., DJ\u2013UBS) is based on 22 commodities and includes liquidity as both a weighting and screening factor. However, the index is selection-based. This means that a committee uses judgment to pick the included commodities and limits the size of the sectors (33% maximum) and floors on individual commodities (2% minimum). Therefore, very different index compositions and weights can occur.<\/p>\r\n<p>In this case, the rolling methodology focuses on owning the front (i.e., near-term) contracts.<\/p>\r\n<h2><strong>Deutsche Bank Liquid Commodity Index<\/strong><\/h2>\r\n<p>It uses a fixed weighting scheme to allocate exposure. It uses the rolling methodology and focuses on near-term contracts. It is optimized based on the time value of maximized backwardation or minimized contango for the contracts that fall within the next 12-calendar months. Note that it takes an active decision with regards to roll return positioning as compared to the other indexes.<\/p>\r\n<h2><strong>Thomson Reuters or Core Commodity CRB Index<\/strong><\/h2>\r\n<p>It consists of 19 commodities and uses a fixed-weighting scheme to allocate exposure.<\/p>\r\n<p>An index management committee decides on the weights based on several factors, including diversification, sector representation, liquidity, and economic importance. It clusters the fixed weights into several tiers; hence components are moved from tier to tier. The rolling methodology focuses on the front and second-front months and does not require a particular calculation.<\/p>\r\n<h2><strong>Rogers International Commodity Index<\/strong><\/h2>\r\n<p>It uses a fixed-weighting scheme to allocate exposure among 37 different commodities. An index management committee makes decisions on the weights based on several factors, including diversification, sector representation, liquidity, and economic importance. It also clusters the fixed weights into several tiers, and the resulting components are moved from tier to tier as they gain or lose relative importance, as seen by the committee.<\/p>\r\n<h2><strong>Rebalancing Frequency<\/strong><\/h2>\r\n<p>From portfolio management theory, rebalancing is more important if a market is frequently mean-reverting because there are more peaks to sell and valleys to buy. Note that frequent rebalancing can lead to underperformance in a trending market since the outperforming assets are sold but their prices continue to rise. In contrast, the underperforming assets are purchased but their prices continue declining.<\/p>\r\n<p>It uses a floating weighting approach, such as production value (fully or partially). The higher (lower) futures prices usually coincide with higher (lower) physical prices. Therefore, the magnitude of rebalancing weights is generally lower than a fixed-weight scheme since the post-rebalance weights will generally drift in line with the current portfolio weights.<\/p>\r\n<blockquote>\r\n<h2>Question 1<\/h2>\r\n<p>Which of the following statements is <em>least likely true<\/em> regarding commodity futures indexes?<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>Commodity sectors in backwardation typically improve index returns.<\/li>\r\n\t<li>An index that invests in several futures exchanges provides a high degree of diversification.<\/li>\r\n\t<li>Total returns of the major commodity indexes have a low correlation with traditional asset classes, such as equities and bonds.<\/li>\r\n<\/ol>\r\n<h4><strong>Solution<\/strong><\/h4>\r\n<p><strong>The correct answer is B.<\/strong><\/p>\r\n<p>Commodity futures exchanges throughout the world are highly correlated and thus provide little diversification benefits.<\/p>\r\n<p><strong>A is incorrect.<\/strong>\u00a0Markets in backwardation typically have positive roll yields. They will, therefore, likely improve index returns (although the price return may still not be positive, and, as such, the total return may still be negative).<\/p>\r\n<p><strong>C is incorrect.<\/strong>\u00a0Commodity index returns do indeed have a historically low correlation with equities and bonds.<\/p>\r\n<h2>Question 2<\/h2>\r\n<p>All factors being constant, compared with an equally weighted commodity index, a production value-weighted index (such as the S&amp;P GSCI) is <em>most likely:<\/em><\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>Less sensitive to energy sector returns.<\/li>\r\n\t<li>More sensitive to energy sector returns.<\/li>\r\n\t<li>Equally sensitive to energy sector returns.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is B.<\/strong><\/p>\r\n<p>The energy sector will comprise a sizable portion of a production value-weighted index and will be a meaningful driver of returns for such an index.<\/p>\r\n<p><strong>A is incorrect.<\/strong>\u00a0A production value-weighted index will be more, not less, sensitive to the energy sector.<\/p>\r\n<p><strong>C is incorrect.<\/strong>\u00a0A production value-weighted index will be more, not equally, sensitive to the energy sector.<\/p>\r\n<\/blockquote>\r\n<p>Reading 35: Introduction to Commodities and Commodity Derivatives<\/p>\r\n<p><em>LOS 35 (j) Describe how the construction of commodity indexes affects index returns<\/em><em>.<\/em><\/p>\r\n<ol><\/ol><!-- \/wp:post-content -->","protected":false},"excerpt":{"rendered":"<p>Commodity indexes have been created to portray the aggregate movement of commodity prices, investment vehicles, and investment approaches. It can be said that an asset class does not exist without at least one representative index. A commodity index plays the&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[562,102],"tags":[],"class_list":["post-23917","post","type-post","status-publish","format-standard","hentry","category-alternative-investments","category-cfa-level-2","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Construction of Commodity Indexes - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Commodity indexes have been created to portray the aggregate movement of commodity prices, investment vehicles, and investment approaches.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/construction-of-commodity-indexes\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Construction of Commodity Indexes - 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