What it means
Commodities are raw materials that are bought and sold in large volumes, such as crude oil, copper and wheat. An index like the GSCI combines their prices into a single number so that investors can follow the broad commodity market.
It is built from futures contracts, which are agreements to buy or sell a commodity at a set price on a future date. The index is production weighted, which means that commodities that are produced in larger economic quantities receive larger weights.
As a result, energy usually makes up a large share of the index. This differs from indices that use equal weights or caps on any one sector.
Because the index follows futures rather than physical goods, its return has several parts. There is the change in the futures price, the interest earned on the cash that would back the position, and the effect of rolling, which means replacing an expiring contract with a later one.
Rolling can add to or reduce returns depending on whether the futures curve slopes up or down. Businesses and investors use the index in different ways.
Pension funds and other investors might hold commodities as a diversifier or an inflation hedge, while analysts use the index as a gauge of price trends. Companies that rely on raw materials may also look at it to understand input costs.
An important caution is that commodity index performance can differ greatly from the price of the physical goods. Rolling costs, the structure of the futures market and the heavy weight on energy all matter.
Anyone investing through an index fund should read how it is built. It also helps to remember that the index has been renamed and reworked over the years.
Different providers publish commodity indices with different weights, so a result quoted for one is not a result for them all. Always check the exact index and the exact version of the return, such as price return or total return.
In practice
Real-world examples.
Example
A pension fund allocates 3% of its portfolio to a commodity index fund as protection against inflation. The investment team reviews the allocation each quarter against the index return. They pay close attention to how the fund handles rolling futures, because the cost of rolling can erode the benefit of holding commodities.
Example
A food manufacturer follows the agricultural part of the index to see whether the cost of grain and sugar is trending up. The finance team uses it as one input when setting budgets for ingredient costs. They also hedge part of the exposure directly with futures, so that a sharp rise in grain prices does not catch the budget by surprise.
Example
A portfolio analyst compares the returns of a global equity fund with a commodity index and finds a low correlation between them. She recommends a small allocation to commodities to reduce overall volatility. The investment committee agrees to a trial and sets a review date, with a rule to reduce the holding if the correlation rises.
Formula
Calculation
Index return = (ending index level - starting index level) / starting index level
Suppose a commodity index stood at 2,000 at the start of the year and 2,300 at the end. The change is 2,300 - 2,000 = 300 points. The return is 300 / 2,000 = 0.15, which is 15%.
An investor who put $100,000 into a fund tracking the index, ignoring fees, would have 100,000 x 1.15 = $115,000.
Index levels are only a scale, so the return depends on the change in level and not on the level itself.Case study
Seen in the real world.
Redstone Asset Management is a fictional firm that launched a commodity fund tracking an index similar to the GSCI. Early on, oil prices rose, yet the fund returned less than clients expected.
The portfolio manager explained that the futures market was in a condition where later-dated contracts cost more than near-dated ones, so each roll reduced the return. The illustrative lesson was that fund returns depend on the structure of the futures curve and not only on the spot price.
Redstone updated its marketing material to explain rolling and expected returns more clearly. In this fictional story, client complaints dropped as expectations became more realistic, and the fund gathered assets steadily because investors trusted the plain explanation.
Watch out
Common mistakes.
- Assuming the index tracks the spot price of physical commodities, when it tracks futures contracts and their rolling.
- Overlooking the heavy weighting toward energy, which makes the index sensitive to oil and gas prices.
- Treating commodities as a guaranteed inflation hedge, when the relationship varies over time.
Questions
People also ask.
What does GSCI stand for?
It stands for Goldman Sachs Commodity Index, now published as the S&P GSCI.
How is the index weighted?
By world production, so commodities with larger production values receive higher weights.
Can I invest directly in the index?
Not directly, but funds and exchange-traded products are designed to track it.
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