More commodity indices – when will it stop?

Dow Jones reported the launch of a new JP Morgan commodity index. This new index will include 33 commodities and tries to reduce some of the problems that have cropped up with other commodity indices. Bloomberg also reported this week that BNP has launched a new commodity index. Right now, if you are bank and you want to be serious about commodities, it seems you have to have your own commodity index.

The new JP Morgan index tries to solve three problems, diversification, weighting, and rolls. It adds more commodities to increase the level of diversification to the index. There are more markets in it than many other indices. Given the low level of correlation across commodities, there will be a significant risk reduction from adding these markets. Second, the index has a new weighting scheme which provides for more equal weighting across the commodities. This again will increase the level of diversification in the index. There will be less depends on the energy complex. The third major feature is that the allocation within a commodity market is across different contract months which will diversify the exposure to the commodity across time. This time diversification will reduce the problems associate with rolls and issue of contango. Indices which are based on futures will underperform the spot market changes when the futures are in contango and outperform the cash market when futures are in backwardation.

The range in performance of all these indices is large. Year to date, the high return index is the Deutsche Bank liquid index which is up 37.17 percent. The lowest return is with the DJ-AIG index which is up 15.42 percent. There is over a 100% difference from the low to high return. This is a fairly large difference relative to what is seen in the equity and fixed income markets. This is due to the fact that there are no agreed upon standards for an index. Some are liquidity weighted while others are production weighted. Some have a focus on nearby contracts while others are divided across maturities. This hodge-podge of indices will become a greater problem for investors because a true benchmark has not been established.

The commodity markets need some standards for benchmarks which can be agreed upon by all market participants. This will add depth to the market and make it more acceptable to institutions. Adding more indices is not the answer.