Uncovering Hidden Risks

Given the five-year anniversary of the equity market rally, further gains expected to remain modest.

Commodity investing has evolved substantially in the last two decades. From exposure to broad-based benchmarks such as the S&P Goldman Sachs Commodity Index ("S&P GSCI") and the Dow Jones UBS Commodity Index ("DJ-UBS"), the asset class has progressed into a myriad of factor-based indices. 

Investors have seen a proliferation of new commodity index strategies, each with different construction methodologies and characteristics such as

  • curve shape,
  • momentum,
  • volatility and
  • particular weighting schemes.

The large increase in these strategies over a relatively short period has created new challenges for investors, including choosing the appropriate benchmark, understanding the weighting methodologies and selecting the right factors.

Normally thought of as "active indices", these new methodologies seek to calibrate beta exposures based on specific quantitative or fundamental factors with the goal of generating better returns than more established benchmarks. Many of these new indices are optimized towards particular factors and events, and may not perform as well in certain market conditions. Often marketed based on back-tested analyses, these strategies can demonstrate inherent performance biases across certain time periods. For investors who are unaware of the particular tilts and biases of these new strategies, these techniques may expose commodity portfolios to unintentional risks.

As investors grapple with the challenges presented by the availability of so many new commodity indices, we believe that discretionary active management—alongside broad, passive beta exposure to the asset class—will play an increasingly important role in commodity investing going forward.

In this paper, we briefly describe how active index strategies are generally developed, review some of the typical construction methodologies and show a comparative analysis of how these indices perform over time.