Use “second generation” indices for commodities, investors told

Investors in commodities should utilise “second generation” indices in order to maximise risk-adjusted returns and avoid flaws inherent in blindly following commodity benchmarks.

The message is based on analysis by exchange-traded fund (ETF) provider Source. It said that first generation commodity indices are susceptible to negative roll-yield, which is due to futures prices for a commodity being higher than current, or spot, prices because of the increased costs of physically holding a commodity such as oil. Contango, or higher futures prices compared to spot prices, is seen as the normal market state for most commodities, although backwardation, or lower future prices than spot prices, is also possible. Source said that second generation indices use a range of tactics to manage the roll process more efficiently, such as selecting different contract months or changing the timing of reinvestments, which can improve trading performance.

Executive director, equities product management at Source, Chris Mellor, commented: “The best way to invest in commodities is through a strategy that offers diversity in commodity weighting, trading strategy and investment counterparts. Second generation commodity indices generally offer better returns with lower volatility than first generation indices such as that in the LGIM Commodity Composite Index offers best risk-adjusted performance than any individual commodity index. Such ETFs are the closest thing to ‘smart beta’ in the commodities arena.”

Mellor added that commodities have risen sharply in 2016, with more than $1 billion of inflows into broad commodity ETFs in Europe and more than $6 billion into physical gold exchange-traded commodities. Source said its analysis showed that commodities have been one of the best performing asset classes when interest rates are rising, bar one period, since the 1970s.