Comparing the Oil ETF to Commodity Indexes

by: Tom Coyne

With the introduction of an ETF based on the price of Brent Crude Oil in London and similar products on the way in the United States, Tom Coyne, editor of The Index Investor compared the simulated historical performance of an oil ETF to the Goldman Sachs Commodity Index and the DowJones AIG Commodities Index. Key points:

The GSCI contains twenty-four different commodities, and weights them on the basis of the average quantity of each that is produced in a given year. The DJAIG believes that pure production weighting underestimates the relative importance of storable commodities (e.g., gold) to the world economy, and overestimates the importance of non-storable commodities (e.g., live cattle). Hence, it uses a weighting scheme based on a combination of production volume and the volume of futures contract trading for each of the nineteen commodities it contains. This difference in weighting schemes leads to one key difference between the GSCI and DJAIG: the weight of energy commodities in the former is almost 80%, while in the latter they are only 33%.

The following table shows the average annual return and standard deviation data in U.S. dollars for the three alternative commodity vehicles, between 1991 (when the DJAIG's simulated history begins) and the end of 2004.

Brent Crude GSCI DJAIG
Average Return 4.39% 4.73% 4.53%
Std. Deviation 29.94% 16.90% 11.35%

The next table shows the correlation of returns between these three alternatives over the same 1991 - 2004 period.

Brent Crude GSCI DJAIG
Brent Crude 1.00
GSCI .53 1.00
DJAIG .43 .87 1.00

The next table shows the correlation of real returns between the different commodity alternatives and U.S. investment grade bonds, commercial property, and equity, over the 1991-2004 period.

Brent Crude GSCI DJAIG
U.S. Bonds 1.00
U.S. Comm. Prop. (.03) .07 .14
U.S. Equity (.14) .04 .11

Based on this analysis, we aren't too enthusiastic about the oil ETF. As you can see, investing in it instead of one of the broader commodity indexes would have generated about the same return, with significantly more risk and somewhat lower correlation with U.S. commercial property and U.S. equity. While, like all statistics based on historical financial returns, these inevitably contain estimation errors, the difference between oil's standard deviation and those on the GSCI and DJAIG is very large. We suspect that it more than offsets any potential diversification benefit from oil versus the other two alternatives in a portfolio. To be sure, we will test this in our upcoming portfolio rebalancing. However, for now our preference for the Dow Jones AIG index remains unchanged.

While on the subject of commodity index products, we should also mention two others that sometimes appear in the media. What was formerly called the "Rogers Raw Materials Index" is now known as the "Rogers International Commodities Index", or RICIX. It includes 34 different commodities, with energy products (crude, heating oil, unleaded gasoline, and natural gas) receiving a fixed 44% weighting. To our knowledge, the only way to invest in the RICIX is through a privately placed security, which means higher costs, plus giving up the liquidity of a publicly traded product. We do not believe the RICIX offers benefits that justify these additional costs. If and when a retail product is introduced that tracks the RICIX, we will reconsider our opinion of it.

The other product is the Commodity Research Bureau Index, which, since June, 2005 has been known as the Reuters Jeffries CRB Index. This index has been around since 1957, but has gone through many changes to both the commodities it includes, and its weighting scheme. The most recent change to the latter came this past summer, which raised energy's weight in the overall index from 17.6% to 33%. While a futures contract on the index trades in the United States, there are no retail products that track it. Between 1991 and 2004 (the same period we used to compare the other indexes), the CRB index delivered average annual real U.S. dollar returns of 1.47%, with a standard deviation of 8.26%. Its correlation of returns with those on other indexes were as follows: GSCI, .63, DJAIG, .80, Brent Crude, .29, U.S. domestic bonds, (.03), U.S. commercial property, .22, and U.S. equity, .18. However, since the index weights were considerably changed in June, these statistics are not a valid estimate of the future performance of the RJCRB index.

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