As equity returns have slumped, so the appeal of alternative investments has risen. Commodities in particular are seen by many as having advantages not just in terms of diversification, but also as assets which can produce solid growth.
In this environment, Standard & Poor’s has lauched its new commodities index. The company has high hopes for the Standard & Poor’s Commodities Index (SPCI), saying the new way the yardstick for tangible goods is calculated makes it much more appealing to traders.
But some say the SPCI is less suitable for investment purposes than its more established rival, the Goldman Sachs Commodity Index (GSCI).
A key feature of S&P’s new benchmark is that it is geometrically calculated, says S&P, whereas its main competitors use an arithmetical methodology.
“One of our advantages is we have an index that is very well suited to trading,” says Robert Shakotko, S&P’s managing director of index services. “The geometric calculation makes it a lot more attractive to traders compared to an index which is calculated arithmetically.”
Geometric methodologies have been widely used in price index calculations. The US Consumer Price Index and Producer Price Index use this method. It works by implying that each commodity included in the index has a constant value share in the index at all times.
Because of the way it is calculated, S&P says the SPCI is effectively rebalanced real-time, maintaining constant dollar exposure across underlying commodities. This rebalancing means the index is forced to buy individual commodities when they are low and sell them when they are high.
This rebalancing, says S&P, leads to trading opportunities between the index futures and futures in the underlying components. This enables the futures contract to trade at a discount to fair value, and this has the effect of ensuring liquidity in the index futures contract, the company says.
In addition to these trading benefits, a geometric methodology generally leads to lower index volatility compared to those indices which are calculated arithmetically, it says. So investors might prefer it from the point of view of risk minimisation
There are already two major commodities benchmarks available. The GSCI, which was introduced in 1991, is the most widely used and there is also the Dow Jones-AIG Commodity Index.
Goldman Sachs says the 10-year track record of its index gives it a great advantage in the marketplace. Heather Shemilt, who runs the GSCI worldwide from New York, says the GSCI has established its position as the premier global benchmark and is a public index with its methodology and data licensed freely.
At the end of 2000 the GSCI had over $8bn indexed to it globally, she says, adding that she knows of no other commodities index that has even surpassed $1bn. “There have also been significant new investors throughout 2001 who’ve made announcements,” says Shemilt.
Pension fund giant PGGM has made a 4% benchmark to the GSCI, which meant around e2bn of assets, she says.
Ontario Teachers’ Pension Plan, the largest Canadian pension plan invested in the market, is another example of an investor that has made a significant allocation to the GSCI.
Shemilt says GSCI futures are listed on the Chicago Mercantile Exchange and have been actively traded there since 1992, OTC swaps are available on the index as well as structured notes – principal and non-principal protected.

The key to the SPCI, says Shakotko, is that it is geared to both investors and traders. “Investors like to have a liquid index so they can adjust their investments efficient and in a cost-effective way,” he says.
S&P has also solved the double counting problem of commodity indices, says Shakotko. Weights of individual commodities within the S& P index are adjusted to remove possible double counting between upstream and downstream commodities.
In some cases, commodities included in an index are inputs for other downstream commodities. Crude oil, for example is used to produce unleaded gasoline, but both are index components. In its index, S&P includes downstream commodities at their full weight, while at the same cutting the weights of upstream commodities to reflect the extent to which they are embodied in the downstream products.
S&P claims another advantage of its index is that it manages to avoid being significantly overweight in energy commodities. It achieves this by weighting components by the dollar value of commercial open interest rather than by world production averages.
The Dow Jones-AIG Commodity Index, which was launched in July 1998, limits weightings of related groups of commodities to 33%, and weightings are based on liquidity or trading activity rather than world production.
But Goldman Sachs defends the heavier energy weighting of its index. “The GSCI is a world production weighted index – what’s being used and produced in the world is reflected in the index on that basis,” she says. “This makes it an excellent investment to track real economic activity.”
Clearly, the fact that oil prices more than tripled in less than two years would have a much bigger impact on the economy than corn or coffee prices tripling, says Shemilt.
The index has been criticised for being 62% energy weighted, she says. But the energy component of the index is what drives diversification, she says. “Energy is the commodity sector most negatively correlated with financial investments,” she says.
“If you have a lower weighted energy index, we would argue you would have to buy more of that index to get the same diversification benefits,” she says. In terms of returns, energy does better than other commodities in periods of global overheating.
When IPE asked PGGM why it decided to stick with the GSCI, Jelle Beenen, senior investment manager responsible for commodities investment at PGGM, said one reason was the GSCI’s high energy weighting. What is seen by some investors as a drawback is viewed as a real diversifying advantage for PGGM, he says.

There were other reasons too. “The fact that it SPCI is a geometric index makes it unsuitable for us, because a geometric index does not reflect an actual position or trading strategy in the underlying commodity futures,” says Beenen.
In trying to replicate the index using the underlying futures, you have to make adjustments to reflect the constant rebalancing in the index, and these adjustments make money, says Beenen. In this way, the replicator makes greater returns than the index does.
“So you can always do better than the index, and this means the index does not comply with PGGM’s rules and regulations concerning benchmarks,” he says.
Investors choosing to invest in the SPCI for commodities via structured notes or total return swaps which pay the return of the index are entitled to receive the rebalancing profit as well, he says. Investors should be aware of this, and negotiate accordingly, he says. But this could prove to be difficult, as the counterparty needs a risk premium because the rebalancing profit depends on the volatility in the commodities markets – which is by definition unpredictable.
The New York Board of Trade has already launched futures and options contracts based on the new S&P index. Following this initial product launch, S&P has already said it hopes to see an exchange-traded fund (ETF) traded on the SPCI.
Shakotko says S&P has already been talking to a number of creators of financial products with a view to licensing the index.
One thing the providers do agree on is that the demand for commodity indices is increasing. “The market is definitely growing because of an increasing need for alternative assets in a portfolio,” says Shemilt.

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