As reported on our pages in early November, both JP Morgan and BNP Paribas have launched new broad-based commodity indexes aimed at capturing returns across the futures curve for 33 commodities.
From our perspective, these new indexes represent a significant shot across the bow at the dominant commodity benchmarks, such as the S&P GSCI Commodity Index and the Dow Jones/AIG Commodity Index, and are part of a larger trend of developing ever-more-sophisticated commodity benchmarks for investors.
The “Problem” In Traditional Benchmarks
The “problem” with mainline commodity indexes stems from our good friend, contango. Mainline commodity indexes like the S&P GSCI and the DJ-AIG typically invest their cash in just the front-month futures contracts for each commodity. When each contract is about to expire, that money is “rolled over” into the next month’s contract.
The problem is that the existing indexes can generate major losses if the front-month contract is cheaper than the second-month contract, which is the situation known as “contango.” Contango is the situation where, and the amount by which, the price of a commodity for future delivery is higher than the spot price.
Contango is actually a normal price relationship, reflecting the costs of carrying the commodity (i.e., costs of storage, insurance, financing) for future delivery. The gold futures market, for example, is typically a contango market: near-term deliveries are priced lower than deferred deliveries.
As my colleague Brad Zigler pointed out in his recent piece, these contango-ed price relationships can play havoc with commodity index returns. The cost incurred is known as “negative roll yield,” and it reduces the returns of the overall investment.
Contango wasn’t a problem when commodity indexes first came on the scene because no one thought the indexes would be investable. Instead, they were designed simply to reflect the returns of the underlying asset class.
But now that commodity-based ETFs have made commodity indexes more accessible, the issue of contango has become more visible.
The two new indexes, the JP Morgan Commodity Curve Index (CCI) and BNP Paribas’ Commodities Market Representative Index [CMRI], provide buyers with investment opportunities “along the curve,” allowing them to spread their maturity exposure out over multiple contract months. In fact, they allow buyers to take exposure as far as three years into the future.
Studies show that this diversified approach dilutes the impact of contango on returns, and allows investors to achieve something closer to the spot return of the commodity indexes.
Of course, commodity markets are not always in contango – sometimes the reverse situation (called backwardation) is in place, and the roll yield is positive. In fact, historically, roll yield has been an important component of commodity returns, and right now, the influential oil markets are significantly backwardated.
Still, in the current commodities bull market, many investors are looking to gain exposure to the spot prices of commodities, and they believe that those prices will rise with continued commodities demand growth from emerging markets. Against that backdrop, the issues of contango and backwardation can be a distraction.
Although both JP Morgan and BNP Paribas are keeping details about the indexes close to the vest, some information is available.
JP Morgan’s CCI, for example, contains futures in 33 different commodities, with a sector breakdown as follows: 46 percent energy, 25 percent industrial metals, 19 percent agriculture, 8 percent precious metals and 3 percent livestock.
One of the CCI’s main selling points is that it includes commodities that haven't been captured by passive commodity indexes before, such as Nymex platinum and palladium, CBOT soybean meal, NYBOT orange juice, Liffe robusta coffee and white sugar, and MGE spring wheat.
BNP Paribas’ CMRI includes futures contracts for 25 different commodities. Those contracts, though less esoteric than those in the CCI, include WTI crude oil, natural gas, Brent crude oil, gold, copper and aluminum. Oil represents 23 percent of the index, followed by natural gas at 12 percent, gold at 6.6 percent and copper at 6.2 percent; corn makes up 5.8 percent of the index.
In comparison, the dominant S&P GSCI and Dow Jones/AIG commodity indexes hold fewer components: 24 and 19, respectively.
Where the new indexes have some catching up to do is in the list of products that have been developed to track the established fund indexes. The Dow Jones/AIG and S&P Goldman Sachs CI both have spawned fund products, ETFs and ETNs to track their performance. To name a few, there is the popular iPath DJ-AIG Commodity Total Return ETN (ticker: DJP), the iPath GSCI total return ETN (ticker: GSP) and the iShares GSCI Commodity Index ETF (ticker: GSG).
Given the fact that both the JP Morgan CCI and the BNP Paribas CMRI indexes just launched, we’ll have to wait a while for meaningful performance data. However, in its press release announcing the CMRI launch, BNP actually provided backtested data. It estimated that performance would have outperformed traditional commodity indexes by 12.4% annually since January 2001, with lower volatility (hypothetically at 14.76%) and a higher risk-adjusted return (hypothetical Sharpe ratio of 0.84).
JP Morgan also said that pro forma historical performance over the last 16 years has been an annualized total return of 9.4% with a volatility of 12.8%, and a resulting Sharpe ratio of 0.39.
In general, however, these portfolios will ebb and flow with the rise and fall of contango in the market. If the markets are in heavy contango (as they were from 2001-2006), these strategies will likely outperform competing benchmarks. If the markets are backwardated, they will probably lag.
Either way, investors will look forward to having new tools to fine-tune their exposure to the commodities marketplace.