What Is a Commodity Index?
A commodity index is an investment vehicle that tracks the price and the return on investment of a basket of commodities. These indexes are often traded on exchanges. Many investors who want access to the commodities market without entering the futures market decide to invest in commodities indexes. The value of these indexes fluctuates based on their underlying commodities; similar to stock index futures, this value can be traded on an exchange.
- A commodity index is an investment vehicle that tracks the price and the return on investment of a basket of commodities.
- The value of these indexes fluctuates based on their underlying commodities.
- Commodity indexes vary in the way they are weighted and the commodities that they are comprised of.
- Commodity indexes differ from other indexes 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.
How a Commodity Index Works
Every commodity index on the market has a different makeup in terms of what goods it is comprised of. The Thomson Reuters/CoreCommodity CRB Index is traded on the New York Board of Trade (NYBOT). This index consists of 28 different types of commodities, including barley, cocoa, soybeans, zinc, and wheat.
Commodity indexes also vary in the way they are weighted; some indexes are equally weighted, which means that 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. For example, some commodity indexes are heavily weighted for energy-related commodities like coal and oil.
The Dow Jones futures index was the first index to track commodity prices in 1933. Goldman Sachs launched its commodity index in 1991, called the Goldman Sachs Commodity Index (GSCI). Goldman Sachs's index was renamed the S&P GSCI when it was purchased by Standard and Poor's in 2007. The Bloomberg Commodity Index (BCOM) family and the Rogers International Commodity Index (RICI) are two other popular commodity indexes.
Investing in commodity indexes gained in popularity in the early 2000s as the price of oil began to move out of the historic $20 to $30 per barrel range that it had occupied for over a decade, and Chinese industrial production started to grow rapidly. The rise in demand for commodities as a result of China's growing economy, combined with a limited global supply of commodities, caused commodity prices to rise and many investors became more interested in finding a way to invest in the raw materials of industrial production.
Commodity indexes differ from other indexes 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, the total return of the investment includes periodic cash receipts–such as interest, 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 when 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 investment performance. If the price of commodities does not go up, the investor experiences a zero return on their investment. A zero return scenario is never 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.