By Drew Voros
S&P's senior director of commodities explains the method behind most widely tracked and watched commodity index.
All commodity indexes are not the same. But what are the differences between the S&P Goldman Sachs Commodity Index, the Reuters/Jefferies Commodity Index, the Dow Jones-AIG Commodity Index, the Rogers International Commodity Index, the UBS Bloomberg CMCI Index and the Deutsche Bank Liquid Commodity Index? Today Hard Assets Investor begins an ongoing series, examining how the major commodity indexes work by interviewing the people and strategies behind them.
Today we talk to Michael McGlone, senior director of commodities for Standard & Poor's, which is responsible for the S&P GSCI Index.
Hard Assets Investor: What's the main difference between the S&P GSCI Index and other major commodity indexes?
Michael McGlone: The S&P GSCI Index was really the first truly investable index. Goldman Sachs created it in 1991. S&P purchased it in 2007. It's generally considered the most widely tracked and the most widely watched index. It has the most significant amount of tracking input and is considered, essentially, the beta for the index. And partly I say that because it's really the only major [commodity] index that is truly world-production weight, which is synonymous with market-cap weighting and the S&P 500. So it's intended to be a pure, investable measure of the world's commodity markets.
In addition, it's also the only [major commodity index] that's from a complete independent index provider. It has the largest "toolbox." It has the largest variety of related indices. The S&P GSCI is one standard. But it has a family of indices that is vast. It's by far the broadest product line and the most widely tracked.
HAI: What is the methodology behind the index's weighting?
McGlone: The index is world-production weighted, as I had mentioned earlier, which is somewhat synonymous with market-cap weighting like the S&P 500. It's why crude oil has a higher weight in the GSCI than corn — because crude oil is the world's most significantly produced commodity, and thus, it should have a more substantial impact when you're measuring commodities than corn does.
A good example is if crude oil goes up a lot in a very short amount of time, it'll have a much greater impact in the global economy than corn does. That's the basis behind the world-production weighted; it's the most defensible. With that in mind, energy is the most significantly produced commodity or sector of commodities, of which petroleum is the main one. And so the GSCI has a high weight in petroleum. Also, in commodity futures, petroleum is the most significantly traded, has the most transparency and thus it gives the S&P GSCI the most liquidity.
HAI: What is the percentage of oil and energy in the index?
McGlone: Energy is currently about 70 percent, but it fluctuates with prices and world production.
HAI: How much does the weighting rely on rising prices?
McGlone: It's subject to rise and changing prices every single day. A good example is Brent crude oil vs. WTI [West Texas Intermediate]. The weighting of Brent over the last few years has increased in the index because of two things: the relative price of Brent has increased, and also because the trading volume, the liquidity, the amount of total dollars of value traded — as we call it in Brent — has increased relative to some of the other petroleum products like crude oil. So price is the significant part. But also, world production is a factor, too.
HAI: How often is the index rebalanced?
McGlone: Once a year. All we do is update the world production weights and update the total dollar value weights within certain world-production commodities. That's done once a year and implemented in January.
HAI: How would an investor know what those changes are?
McGlone: Each time we change what we call the contract-production weights, which is done once a year. We change the weights of each constituent and we put out a public announcement.
HAI: How much capital is tied to the index investment?
McGlone: About $100 billion. That's likely increased this year. But we don't have a definitive estimate out yet.
HAI: What are the percentages of physical commodities vs. contracts in the index?
McGlone: There are 24 commodities in the index. And they're all based on the price of the futures that track the indices. The only way to really track a broad basket of commodities is through futures. So they're all physical commodities in the index, but they're tracked by futures prices.
HAI: How do you answer critics who say that the index is too heavily weighted toward oil and energy? And is that really representative of commodities as a whole?
McGlone: It's the same reason the S&P 500 has a higher weight in GE than it does in Illinois Tool Works, because what's more significant in terms of equity? What's more significant in terms of commodity? So that's the base S&P GSCI and that's the world's benchmark. And to be a world benchmark, you can't equal-weight corn with crude oil or you're implying that the corn is equal in significance in terms of the global commodity market with crudes. We like to defend that by saying that's how you really properly measure beta: by world production.
HAI: Because of world-production weighting, when something like oil moves, does it takes other commodities with it?
McGlone: We call that a spurious correlation. There's generally not a high correlation between the price of energy and agriculture. There generally is a high correlation between the global economic supply/demand situation and the economic sense of commodities, like energy and like the industrial metals. Generally, there's actually a very low intra-commodity correlation within the index. For instance, all the softs [commodities] move differently. Sugar is up a lot this year. Cotton is down a lot. Things like silver and gold will move together. I think it's generally accepted that intra-commodity correlations are much lower than equities.
HAI: How do you determine the market cap for wheat?
McGlone: We don't. What we do is use what is the world production of wheat. We come up with that contract-production weight based on what is the global production of wheat. We don't just take one year. We take an average of the most recent five-year period. We can line up all the commodities together, get all the data, and say, "What was the global production, the average over these five years, of wheat?"
This year there are two wheat contracts in the index. There's Chicago wheat and Kansas wheat, partly because we've determined both are significant and need to measure wheat in the market. But for the first time in a while, the actual weight of corn in the index has increased above that of wheat, partly because the price of corn has gone up more. But generally the weight of world production of every commodity is how we determine the significance in the index. And then, of course, the price will move.
HAI: So when you're determining the market cap for wheat, you do it twice?
McGlone: No, I should clarify: We do the world production of wheat once, but we also have two futures contracts to represent that in the index. The way we do that is we break out the weight of each futures contract based on their total dollar value traded. So wheat that trades on the Chicago Board of Trade will have a higher weight than wheat that trades in Kansas because it has a higher total dollar value traded.
But the total weight of those two futures combined, which we consider a component, is equal to world production. There are only three commodities that are considered components that have more than one future that actually track that world production representative. There's wheat. There's cattle — which includes live cattle and feeder cattle — and then there's petroleum. Petroleum includes crude oil, WTI crude oil, Brent, gas oil, heating oil and unleaded. And the weight of all those is considered. But then you have to break out the weight within that component among those widely traded futures, based on their total dollar value traded.
A good example would be, if there was only one petroleum commodity; let's say it was heating oil. Then that heating oil future, that single future, would represent the total weight of crude oil. But since there are five very liquid ones, we include all five.
HAI: Explain the use of the front-month roll on your contracts.
McGlone: Liquidity is part of the main focus. The index can never be perceived as impacting the market, so we have to use the most liquid, front-month contract at all times. And of course, it has to roll out of those before they become anywhere near deliverable. We say "the front-most active" because sometimes there can be a contract at the front, but it's not the most liquid. So the index is, No. 1, designed to measure the market. And No. 2, it has to be investable. And by investable, it has to be as liquid as possible.
The actual front month might not always be the most active. So we always have to say the front-most active. A good example is gold. Gold sometimes has these contracts that are not liquid. It might be the front, but we always focus on the most active contract. So we have to clarify the two terms: front and front-most active.
HAI: Someone looking at the index might wonder why gold and precious metals are so low weighted, especially with everything that's going on in the markets.
McGlone: We are completely strict on the base S&P GSCI. It's a methodology-driven index. It means there's very little human intervention. It's very much a rules-based index. The weight of precious metals has increased in the index only because the price of precious metals has increased. The weight of industrial metals has decreased because the price of industrial metals has decreased. But the actual contract-production weight, its theoretical amount of contracts that the index holds, has not changed.
For instance, if you have a stock in an index, and you have 100 shares in that stock, and, at the end of the year the stock goes up 50 percent, and the rest of the index is unchanged, of course the stock will have a higher weight, even though it still has only 100 shares.
But the significance in industrial metals and precious metals, this year, is that industrial metals have been the worst-performing sector index. Precious metals have been the best-performing sector index, which has some significant economic implications.