Commodity markets across the globe provide the basic raw material for the development of an economy and understanding of the commodity markets, and its performance could serve as porter’s lens for investors to reckon the economic cycle, patterns, and conditions.
While commodity provides input for the product generation, understanding the global market could be a tedious task amid variable prices of the same commodity in different geographies; however, the importance of understanding its performance cannot be overlooked.
So, do you have to know the nitty-gritty of the international commodity market? Or is there an alternative method to avoid the tedious and gigantic task.
To answer, Yes there is an alternative option to gaze upon the global economic conditions, without knowing the in and outs of the global commodity markets, and without tracking individual commodity and study their correlation with the global economic conditions.
Difference between Commodity Indices and Traditional Indices
The Commodity Index is a collection of various commodities and tracking the price behaviour of the right indices could be beneficial for the investors, who are unaware of the complex investment world of alternative assets including, commodities.
Financial securities are generally traded in centralised spot markets, and so most indices related to traditional investments focus on prices from cash markets. However, the performance of physical commodities are generally better measured using prices of a futures contract as compared to the spot or cash prices, as the prices of physical commodities are not centralised, and spot prices vary with geographies.
The prices of spot commodities also cannot be arbitrated to net-zero amid transportation cost, and also the shares of a particular security are homogenous and trade at the same price (post considering the exchange rate), some commodities have different grades or qualities that trade at different prices.
Due to the aforementioned reasons, the commodity indices are constructed on the futures contract as compared to the traditional asset indices, which are constructed on the spot or the cash prices.
The commodity indices are typically constructed to be unleveraged, and the face value of the futures contract is either collateralised either by cash or riskless bonds like Treasury Bills (T-bills).
In the construction of a commodity index, futures contract are purchased, i.e., a hypothetical long position is established in the underlying commodity futures of the expiry in hand, or the near expiry or swap agreements are entered to provide economic exposure to commodities equal to the amount of cash being invested in the index.
Therefore, every unit of money (be it $, USD, RMB) that an investor exposes to a commodity futures index has generally similar risk to having a unit of money invested directly in commodities.
Where to Use a Commodity Index?
Commodity Indices of Economic Importance
- The Standard & Poor’s Goldman Sachs Commodity Index (Or S&P GSCI)
Originally constructed by the Goldman Sachs and purchased by S&P in 2007, the S&P GSCI is a composite commodity index which measures the performance of the commodity market and could be comparable to the market indices of traditional assets such as S&P 500 and Dow Jones.
The index shows the basic characteristic of commodity indices and is a long-only, unleveraged index, which provides diversification to the investment via exposing the investment to the commodity futures.
On the economic implications, the S&P GSCI covers five major sectors, i.e., energy, industrial metals, precious metals, agriculture, and livestock, of an economy, and is consists of 24 exchange-traded futures contracts of physical commodities.
To gauge the economic output from the S&P GSCI, one has to understand its composition. We mentioned the five sectors included in the index, now let us take a look over the weighting shifts of the index every year.
The S&P GSCI index is base upon the liquidity and weighted according to the global production levels and get rebalanced annually.
When the overall global economy is thriving, the energy, industrial metals, agriculture, and livestock are in great demand, which in turn, prompts investors to finance the activities related to the production of the raw material from these sectors
Higher allocation towards energy, industrial metals, and agriculture represents higher global production from these sectors, and during the expansion of an economic, the supply tries to meet the demand to maintain the equilibrium; thus, a higher allocation towards these sectors generally represents an expansion in global economies.
- The Bloomberg Commodity Index (Or BCOM)
Originally constructed by AIG in 1998, the BCOM is a long-only index composed of the futures contract on 22 physical commodities. The commodities included in the index is widely diversified and includes, petroleum products, natural gas, precious metals, industrial metals, grains, livestock, soybean, oil, coffee, cotton, cocoa, and sugar.
The BCOM index is calculated on an excess return basis, and the index gets rebalanced annually. The weight distribution of the index is different from the S&P GSCI as the index takes 2/3 of its weight from the trading volume, and 1/3 of its weight from the world production level.
The weight method of the BCOM index family further ensures that no single commodity sector dominate the index, and the index remains free of the micro-economic events, which hampers or dictate the prices of one particular sector or commodity.
While the S&P GSCI is a pure production-based index, the BCOM family allocates higher proportion to the market volume, which in turn, makes BCOM more attractive, as it helps to gauge both the market mood and economic importance.
In theory, market remains efficient as they are informed well, when the trade volume in a particular commodity rises unusually to the higher levels, it is generally presumed that the demand for the commodity is high, which in turn, also helps in understanding the economic development, if an investor is clear with the economic importance of the particular sector; even if not, the market mood dictate the prices and sets the trend.
The water allocation prices in Australian bears a relevant example of such a correlation. The allocation prices for water entitlements doubled in the recent past, which was deeply followed by the rise in the volume of entitlements trade.
To Know More, Do Read: Australian Water Entitlement- An Emerging Alternative Asset
Thus, by tracking the allocation of BCOM and its value, an investor could easily gauge the overall mood of the market along with the global economic conditions.
- Reuters/Jefferies Commodity Research Bureau (CRB) Index
The Reuters/Jefferies Commodity Research Bureau Index is the oldest major commodity index, which was first calculated by the Research Bureau Inc. in 1957. The index currently incorporates 19 commodities traded across various exchanges around the globe.
The index takes a four-tier grouping system to weight the commodities, and the index is designed in such a way that it reflects the importance of each commodity to global economic development.
As the commodities’ price hold a positive correlation with inflation, the index is favourably tracked by both the commodity investors and the bond investors.
The increase in the value of the Reuters/Jefferies Commodity Research Bureau Index typically represents thriving economy, in which risky assets generally provide a higher return as compared to bonds, so, the bond investors also track the index thoroughly, and the index holds some value in the investing community.
The index is currently divided into four-tier, where tier-1 contains petroleum products with 33 per cent of the total index weight. The second tier or tier-2 contains highly liquid commodities, while tier-3 and tier-4 provide diversification and broad representation for the index.
In a nutshell, the commodities and their positive correlation with the global economic conditions, make the aforementioned index valuable among investing community, and a novice investor can also utilise the same to gauge the level of economic play and demand & supply dynamics in the international market.
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