The index of commodity futures investing

http://www.thehindubusinessline.com/2007/01/04/stories/2007010400060800.htm
V. SHUNMUGAM D. G. PRAVEEN
Investing in commodity indices that are efficiently designed would serve the dual purpose of removing the fear of physical deliveries besides better returns with a moderate risk — the key areas of concern in India. Confirming after a study vis-à-vis other key markets that India has sustained a bull run in commodities, V. SHUNMUGAM and D. G. PRAVEEN think that index investing is the way to go.

There is a general wariness, especially among retail investors (though often institutions are also extra cautious), in trading in commodity derivatives for fear of ending up in a delivery situation and the lack of an efficient portfolio that would keep the value of their investments in commodities growing.

A way out would be investing in commodity indices that are efficiently designed for such purposes. This would remove the fear of physical deliveries besides ensuring better returns with a moderate risk. Such commodity indices not only provide an investment opportunity, but also an alternative risk mitigation mechanism for investors. As such, investing in indices is not new to investors in India, as indices based on spot and futures securities market are popular on the stock exchanges.

Derivative indices
However, commodity derivative indices are different from their financial counterparts in that the underlying physical assets range from paper pulp to gold, to live cattle and crude oil, sourced from diverse corners of the world.

Globally, half a dozen popular indices reflect the futures prices of commodities from different underlying markets. The list includes the Goldman Sachs Commodity Index (GSCI), the Dow Jones-AIG Commodity Index (DJ-AIGCI), the Reuters CRB Commodity Index (RCRBCI), the S&P Commodity Index (S&PCI), the Rogers International Commodity Index (RICI), and the Deutsche Bank Liquid Commodity Index (DBLCI). According to Goldman Sachs, about $80 billion is invested globally in the commodity derivatives of which 60 per cent (about $48 billion) goes into passive index-tracking instruments.

Commodity vs. Stock Indices
The prices of exchange-traded stocks are available on a continuous basis; hence, construction of index based on this data is simple and possible real-time. Contrarily, prices of commodities (of a particular quality) are not readily available on a continuous basis. To have an index that reflects the fundamentals and is actively tradeable, it would be best to construct an index using future, rather than cash, prices in the absence of effective spot exchanges for commodities. However, futures contracts expire on the date of maturity. So in order to have continuous futures prices, commodity indices are constructed such that the futures prices of given maturities are considered and replaced with (rollover to) the subsequent month's contracts.

Futures indices
The popularity of the commodity futures indices would have wide implications on the futures segment itself. Investment in indices is normally a long-term strategy that can excite interest in futures contracts for various commodities as investors get a grip of the fundamentals. Another interesting proposition could be that participants can take strategic positions in the indices and the underlying commodities to profit from arbitraging opportunities. A comparative financial performance analysis of four global benchmark indices and MCX Comdex was done for the period December 2005 to December 2006 to look at their performance and to find if the Indian commodities were on a "bull-run" during this period.

Goldman Sachs Commodity Index (GSCI): The most widely followed commodity index was created in 1991. The weights are assigned to the underlying commodities based on their average production value in the last five years of available data. The liquidity on the exchanges is also considered. Weights and composition are reviewed and re-assigned annually.

Dow Jones AIG Commodity Index (DJ-AIGCI): Created in 1998, it comprises 19 commodities. The weights to the underlying commodities are assigned and re-adjusted annually based on average global production and average trading volume over the latest five years.

Reuters/Jefferies Commodity Research Bureau (R/J CRB) Index: Developed in 1957, it is one of the most popular indicators of overall commodity prices. It reflects prices of 19 commodity futures traded on benchmark exchanges. CRB was traded first on New York Board of Trade (NYBOT).

Rogers International Commodity Index (RICI): Developed in 1998 by Jim Rogers to record the price movements of raw materials on a worldwide basis, it has the largest basket with 35 commodities.

Weights for the underlying are assigned monthly according to their importance in international commerce.
MCX Comdex: It was created in June 2005 to mirror the commodity prices discovered at the Multi Commodity Exchange of India (MCX). Like the GSCI, there is no limit on the number of underlying commodities. The MCX Comdex now tracks 10 commodities selected on their liquidity and their importance to the physical market. Equal weights are assigned at group level (energy, agriculture and metals). It relies on a unique combination of liquidity on MCX and physical market size to determine its component weighting. Only near or near-deferred contract months are taken for the index computation.

Currently, gold, silver and copper represent the metals group, while energy and agriculture groups comprise crude oil, and soya oil, cottonseed oilcake, wheat, rubber, urad and guarseed. The index is not traded on any of the exchanges in India due to regulatory constraints. Among the benchmark indices studied only MCX Comdex and RICI had positive returns for the period. The Indian benchmark MCX Comdex provided the highest annualised return of about 18.33 per cent with a moderately higher annualised risk (19.31 per cent). This was followed by the RICI, with an annualised return of 5.56 per cent (annualised risk: 17.04 per cent).

The other benchmarks showed negative returns, ranging from 1 per cent to 7 per cent. This implies that the Indian index has been steadily bullish compared with its global counterparts most of which are in the negative return zone.

Over-emphasis on energy
Looking at the basket of commodities considered for these indices, the over-emphasis on energy has made GSCI highly volatile compared with others with an annualised risk of 22.87 per cent. The high volatility reduced the return-risk ratio to - 1.35. Measured in terms of return-to-risk ratio, at 97.5 per cent, MCX Comdex again tops the charts leaving its counterparts way behind.
Despite the closed borders in various commodities, MCX Comdex had a very high correlation with its global counterparts ranging from 66.1 per cent to 82.7 per cent due to its unique combination of metals, energy, and agricultural verticals representing the entire range of primary commodities.

Through its innovative design, MCX Comdex had not only proved that Indian commodities had a steady bull run in the international markets during the last one year, but also that it is a better barometer of the primary commodities price complex by having better correlation with its global counterparts.

(The authors are, respectively, Chief Economist and Manager, Multi Commodity Exchange of India Ltd. The views are personal. They can be contacted at v.shunmugam@mcxindia.com or Praveen.d@mcxindia.com)