Commodities

June, 2006

Commodities investing is getting to be like English weather. If you don't like what's on offer today, just wait a bit, and it will change. This past month has seen the introduction of two new commodity indexes. The Lehman Brothers Commodity Index contains twenty commodities and annually resets their weights based on their futures trading volume. These weights then adjust during the year based on price changes. The current weight of energy commodities is about 53%, with metals at 27% and agricultural products at 20%. The Merrill Lynch Commodities Index contains eighteen commodities. They are initially selected based on their futures market liquidity, and then weighted by their importance in the global economy. Their current weights are energy, 60%, Metals, 17%, and agriculturals, 23%.

The following table shows how these weightings compare with other commodity indexes (GSCI = Goldman Sachs Commodities Index; DBLCI = Deutsche Bank Liquid Commodities Index; RICI = Rogers International Commodities Index; DJAIG = Dow Jones AIG Commodities Index):

	GSCI	MLCX	DBLCI	LBCI	RICI	DJAIG
Energy	74%	60%	55%	53%	44%	33%
Metals	12%	17%	23%	27%	21%	26%
Agric.	14%	23%	22%	20%	35%	41%
High-Low Weight	62%	43%	33%	33%	23%	15%

When it comes to weighting, we will reiterate a comment we've made before: the most reliable source of commodity index returns over time is the "diversification yield." This is the benefit that results from holding a portfolio of commodities whose returns have low correlations with each other (see, for example, "The Tactical and Strategic Value of Commodity Futures" by Erb and Harvey). However, as Kat and Oomen note in a new paper ("What Every Investor Should Know About Commodities"), the correlations between the returns on different commodity groups (i.e., energy, metals, and agriculturals) are much lower than between the returns on commodities within each of them. Hence, the diversification yield should be maximized (and volatility minimized) when different commodity groups are held in roughly equal proportions. Hence our continued preference for the Dow Jones AIG Commodities Index. As you can see in the table above (specifically, the high minus low weight row), it is the most balanced of all the commodity indexes available today.

However, there is more to the new index products than simply their weighting schemes...

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