A commodity index monitors a group of commodities to gauge how they are doing. These indexes can be traded on exchanges enabling investors to easily get to commodities without having to go through the futures market.
A commodity price index is a fixed-weight index or (weighted) average of chosen commodity prices, which may be either futures or spot prices. It is intended to be indicative of the wide-ranging commodity asset group or a special sub class of commodities such as grains or metals.
Despite the fact that the constitution and arrangement of every index is widely divergent, their purpose is the one and the same - to check on a collection of commodities.
Components: Every commodities index applies a particular technique to find out which commodities can be incorporated into the index. Certain indexes consist of commodities depending on their worldwide production worth, while others take in commodities depending on their liquidity and the distinguishing feature of a component group: For example, selecting gold to signify metals and oil to denote the energy market.
Weights: A number of indexes abide by a production-weighted system, wherein weights are given to each commodity depending on its commensurate global production. Other indexes opt for component weightings depending the liquidity of commodity's contract futures. Furthermore, some weightings are unchanging over a given time period, even as others rise and fall to indicate changes in real production values.
Rolling technique: Given that the index's objective is to monitor the action of commodities and not receive concrete transfer of the commodity, the futures contracts that the index monitors should be rolled over from the present month contract to the forthcoming month contract. Given that this rolling method gives a roll yield (that is, the earnings that come about from the differences in prices between the present and the forthcoming months), each index's guidelines on rolling should be studied.
Rebalancing aspects: Components and their related weightings are routinely assessed by every index with the aim of establishing an index that displays actual values of the worldwide commodities markets. Even as a number of indexes rebalance on a yearly basis, a few others rebalance more often. Rebalancing apportions additional capital to assets that are not performing well by removing it from assets that are doing exceedingly well. It is advisable to determine beforehand when and how indexes are rebalanced prior to investing in one.
Although commodities index is built distinctively, all indexes have to adhere to definite factors to decide whether a commodity will be incorporated in the index.
Capable of being traded: The commodities should be capable of being bought and sold on a selected exchange and have a futures contract attached to them. For instance, steel though an essential commodity does not find a place on an index as there are no futures contracts for steel.
Capable of being delivered: The agreements that fit into index must be for commodities that are capable of being physically transferred. Thus, futures contracts that denote financial vehicles such as interest rates and economic indicators are totally excluded.
Sufficient Liquidity: The market for the concerned commodity should be sufficiently liquid to enable investors to shift their stance without confronting a liquidity crisis, such as being unable to locate a purchaser or seller.
The Commodities Research Bureau (CRB) index, which began operations in 1986, is the geometric average of its components, each of which are assigned equal weights.
The Goldman Sachs Commodities Index (GSCI), formed in 1992, is traded on the exchange, and consists of 24 commodity futures contracts. Components are given weights depending on a five-year moving average of global production values and rebalancing is done on a yearly basis.
The Rogers Raw Materials Index (RRMI) started in 1998, is a wide-ranging index, covering 35 commodities and is traded on exchanges. Assets are weighted in relation to their significance in worldwide trade. Commodities are given fixed weights and the index is rebalanced monthly.
Dow Jones-AIG Commodities Index (DJ-AIG) established in 1999, has contracts futures on physical commodities. Commodities should have a bare minimum weight of 2% and a maximum of 15%. A sector's weight cannot surpass 33% of the index at the commencement of a calendar year. The index is rebalanced on a yearly basis.
In general, commodities index serve as a yardstick for investment in the international commodities markets and as a gauge of commoditie activity in due course of time.