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10. Commodities

FEATURE: When most ordinary investors think of commodities, they tend to think of the spot prices that are quoted in the media
January 29, 2010

When most ordinary investors think of commodities, they tend to think of the spot prices that are quoted in the media. In reality, though, most professionals tend to ignore this as an investable idea – instead, they use an index that incorporates some form of futures contracts across a range of different commodities, called in the trade a 'composite index'.

The S&P Goldman Sachs Commodity Index is perhaps the most widely-used index and is what's called a 'production-weighted benchmark' of two dozen commodities adjusted for liquidity – it's currently heavily weighted in energy products; 40 per cent of the index's weight comprises crude oil futures. Agricultural and soft commodities, such as wheat and sugar, make up 11 per cent, metals 6 per cent and livestock 2.86 per cent. Because the GSCI index is based around this notion of 'world production', the constituents can vary widely – the dominant energy sector, for example, has varied over time from 44 per cent per cent through to 78 per cent, making it very volatile indeed.

The Dow Jones-UBS Commodity Index sits at the core of the ETF Securities range of funds. It's made up of 19 commodities weighted primarily for trading volume, and secondarily on global production, with floors and caps on component weights. Crucially, the index has been set up so that no single commodity can comprise more than 15 per cent of the index, and no single sector can make up more than a third of the benchmark’s weight. By sectors, energy now carries the biggest weight of 33 per cent, followed by industrial metals at 20 per cent, precious metals at 10 per cent, softs at 8.7 per cent and grains at 18 per cent.

The Deutsche Bank Liquid Commodity Index consists of only six commodities, based around the most liquid (in trading terms) commodities in each sector. There is no exposure to livestock or softs in this index. Lyxor offers a small family of index funds that track the CRB Commodity Index. This index is made up of 22 futures contracts combined into an 'All Commodities' grouping, with two major subdivisions: raw industrials and foodstuffs. Metals make up 20 per cent, energy carries a weight of 39 per cent and soft commodities 39 per cent.

The Rogers International Commodity Index, devised by legendary investor Jim Rogers, is the broadest and most international of all the indices. The RICI consists of 35 commodities, including such exotics as azuki beans, silk, rubber and wool.

All of these indices are very broad-based and include a wide range of underlying commodities futures – they are all composite indices. Some investors may want to buy exposure to commodities but want to exclude energy-related commodities and you can buy sub indices that bunch commodities into energy and non-energy components or baskets. These basket indices tend to break down into four main sub groups:

■ Energy commodities;

■ Agriculturals, broken into softs and hards plus livestock;

■ Industrial metals including copper and nickel;

■ Precious metals.