What is a 'Commodity Index'

A commodity index is an investment vehicle that tracks a basket of commodities to measure their price and investment return performance. These indexes are often traded on exchanges, allowing investors to gain easier investment access to commodities without having to enter the futures market. The value of these indexes fluctuates based on their underlying commodities, and this value can be traded on an exchange in much the same way as stock index futures.

BREAKING DOWN 'Commodity Index'

There is a wide range of commodity indexes on the market, each of them varying by their components. The Reuters/Jefferies CRB Index, which is traded on the NYBOT, comprises 19 different types of commodities ranging from aluminum to wheat. They also vary in the way they are weighted; some indexes are equally weighted, meaning each commodity makes up the same percentage of the index. Other indexes have a predetermined, fixed weighting scheme that may invest a higher percentage in a specific commodity, such as energy related commodities like coal and oil.

Some of the first commodity indexes were constructed by the investment bank Goldman Sachs as early as 1991. Investing in commodity indexes gained in popularity in the early 2000's as the price of oil began to move out of its historic $20-30 per barrel price range that is occupied for over a decade and Chinese industrial production started to grow rapidly. This rising Chinese demand and limited global supply of commodities caused prices to rise, and investors were keen to find a way to invest in these raw materials of industrial production.

Limitations of Commodity Indexes

Commodity indexes differ from other indexes like stocks and bonds in one very important way, the total return of the commodity index is entirely dependent on the capital gains, or price performance, of the commodities in the index. For most investments, total return includes periodic cash receipts such as interest and dividends and other distributions as well as capital gains. For example, stocks pay dividends and bonds pay interest, which contributes to the investment's total return even if there is no increase in the investment's price. Commodities do not pay dividends or interest, so an investor is dependent solely on capital gains for the investment performance. If the commodity price does not go up, the investor experiences a zero return on investment. This zero return scenario is not the case for bonds that pay interest and stocks that pay dividends. For example, if a stock price is the same at the end of the investment horizon, but has paid a dividend, the investor will have a positive return on investment.

 

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