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Commodities in investment portfolios: The index way

By V Shunmugam

The history of indices dates back to the early 18th century, when the Anglican bishop William Fleetwood wanted to examine if the 5 net worth cap for a candidate to remain in a college should be kept at that level (fixed during the 15th century) or does it need to be updated, using a set of commodities of daily consumption. Notably, more than his findings, which had indicated that the same should be increased to 30, commodity prices in an index format were considered to decide on a financial policy. The index, as a statistical tool to monitor the impact of economic events, was not only devised at first using commodities that tended to dominate consumption and trading, but was also applied to assist in decision-making. A century later, the popular journal The Economist had devised and started publishing commodity-price index in 1864.

As the economy got financialised and investment in stocks took off later in the 19th century, the index as a tool to measure the overall health of the stock markets took off, with Charles H Dow and his companion Edward Jones unveiling the first stock index in 1884 the Dow Jones Average, through which the selected 12 top stocks traded. Later, when it got published on a daily basis during 1896, it became an index of 32 stocks and is now a 30-stock index a simple yet a widely watched indicator of the health of the US stock markets till date. This was followed by the calculation of the S&P 500 and within themselves these two indices also caught fire as portfolio management tools for managing investor funds in a more transparent manner as they are calculated and published on a real-time basis and hence their performance is easily measurable. Within themselves, these two indices today are used to manage a portfolio of $13.7 trillion in assets and are used as a benchmark for investment assets of $8.8 trillion the S&P Global 2018 Investor Fact Book.

Although commodity-based indices have been used for the last three centuries or so in tracking the economic health and to assist in policy decision-making, investing in commodity indexes has been a recent phenomenon, dating back to 1991, following the introduction of the Goldman Sachs Commodity Index (now S&P GSCI) and the Dow Jones AIG Commodity Index (now the Bloomberg Commodity Index, or BCOM) in 1998. While these indices, in themselves, track the prices of the respective underlying commodity futures contracts, they also have futures contracts traded to be settled on these indices with an annual turnover of $30 billion (2018). Comprising of liquidly-traded commodities from global benchmark exchanges, these commodity indices also continue to dominate as benchmarks in index-based investments in the commodities world, with about $90 billion assets under management (AUM) tracking the portfolio of the index basket. Investing in commodities picked up momentum in the 2000s, particularly through index-based products providing exposure to financial contracts in commodities from various exchanges through one index in a transparent manner without the risks associated with physicals. Barclays (2019) indicated that the global AUM in commodities stood at $282 billion by the end of 2018, and a substantial part being managed through commodity indices.

The introduction of trading in index-based derivatives had also played a significant role in the development of international commodity derivative markets, bringing more liquidity and efficiency through providing widespread access to commodities for diversified investors as demonstrated by the international as well as Indian stock markets. The introduction of index-based derivative products in equities in 2001 on domestic exchanges has led to remarkable growth in both the cash and derivative segments, thereby contributing to the overall development of the market during the past two decades. The total turnover of equity markets stands at more than 10 times the country s GDP (in 2017-18), with a phenomenal growth of index-based derivative segment from about Rs 103 crore in 2001-02 to Rs 5.68 lakh crore in terms of average daily turnover.

Drawing lessons from global experiences, investing in commodity index-based products would provide potential portfolio diversification opportunities for domestic investors due to a very low or negative association with traditional assets, as is evident from the negative correlation of iCOMDEX with NIFTY 50 (-0.78) and Treasury securities (-0.81 with 91DTB) market during January 2012 to February 2019. Commodity derivatives will continue to be a part of the portfolio of players who know and understand the fundamentals of commodities that they take exposure to. Further, index based ETFs would help other institutional participants to a basket of commodities setting off the physical commodity risks. With trading in commodity indices being allowed post SEBI approval, and institutions and current participants effectively arbitraging the underlying and the index, commodity index derivatives will become an efficient tool in portfolio management for all institutional participants.

Investing through indices consisting of a basket of commodities representing a common theme also provides an opportunity for investors to track those themes. A clear case in point is the TR-MCX iCOMDEX Base Metals Index, which largely represents the global economic growth and is also known to move along the lines of the Chinese economic indicators. For example, China growth expectations and the base metals index show a correlation of 76%, indicating the strength of relationship. Further, investing in index-based products eliminates issues around delivery, lot size, etc, associated with physical commodities, while providing the benefits of price movements of the underlying commodities. In addition, segment-wise commodity indices including precious metals, base metals, energy and agricultural commodities, etc, are similar to sectoral indices in equity markets, where investors can choose to invest in portfolios tracking specific segment of commodities such as bullion index, energy index, etc, apart from the iCOMDEX composite index. These segment-wise commodity indexes, being least correlated with other assets and with each other, are proven to deliver diversification benefits for portfolio investors, in addition to their inherent advantage as inflation-hedge.

Commodity index-based investment vehicles include exchange-traded derivatives such as index futures, swaps and options or various index-linked funds including exchange-traded funds or notes (ETFs or ETNs), index funds and mutual funds. ETFs, ETNs and index funds remain passive investments, while mutual funds use active investment strategies. Among index-based investment products, ETFs are the most popular instruments among global investors, particularly institutional investors and fund managers.

Commodity-based mutual funds also typically use commodity index-based derivative instruments to build the exposure to commodities along with other traditional assets and provide investment opportunity for a varied set of investors reaching out to even small investors that are constrained to do commodity-based investments not only due to their limited financial resources, but also due to lack of required knowledge and technical know-how. PIMCO CommoditiesPLUS Strategy Fund is one of the major commodity index-based mutual funds with investment strategy tracking the Credit Suisse Commodity Benchmark having assets of $3.1 billion as on March 13, 2019.

-The author is head, Research at MCX. Views are personal