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Trade of the Month: Commodity Indexes

Tim Mortimer
Future Value Consultants
June 2011

Although equities are the most popular and natural choice for retail products, commodities are a good niche choice for two main reasons. First, when the increase in value of commodities is very strong, and second as a diversification from equities. Because commodity prices often exhibit complex pricing patterns driven by supply and demand, many commodity indexes have been created in order to provide a more reliable measure of commodity price performance.

All indexes must be ‘investable' to have any real use - that is, subject to a reasonable tracking error, an institution can follow the investment strategy that defines the index and replicate the values of the index in a holding. This requirement is necessary as it will form the basis of the hedging strategy. If a fund or structured product is to be issued linked to a certain index, then the institution needs to be able to create the returns for that index just as if it were a simpler asset such as a stock.

All commodity indexes differ fundamentally from equity indexes because the latter are linked to stocks while the former are linked to futures, as holding the underlying spot commodities is not feasible due to storage costs and other issues associated with physical holdings.

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