Passive investment has gained broad acceptance as a valid investment choice across a range of asset classes, notably equities and bonds in developed markets. Are the benefits of passive investments transferable to commodities?

Providers of index-tracking products cite several key features namely low fees, simplicity and liquidity.

Given the 30% decline in commodity markets[1] in the fourth quarter of 2008, are these benefits worth paying that much for? This note looks at whether passive investing is applicable to commodities and whether active managers are a better alternative.

Passive Investments Use Fixed Weights To The Largest Traded Commodities

Equity indices set weights based on the largest companies – in essence the ‘winners’. In bonds, weights are based on large issuers of debt. For commodity indices, weights are set based on commodities with the largest trading volume or greatest consumption in the global economy. Passive indices set weights generally at the start of the year and drift with price changes through the year.

This means that investors are tied to significant exposures to the commodities with the highest use. This typically leads to excessive exposure to energy commodities. Even in the DJ­UBS index where the exposure to energy is capped to provide a more balanced exposure, just seven commodities account for 61% of the index (crude oil, natural gas, gold, copper, aluminum, corn and soybeans). This means that investors are ‘locked ­in’ to the returns of just these major commodities. Sugar, one of the best performing commodities this year, has only a 3% weight in the DJ­ UBS index.

Commodity Indices Are Narrowly Focused

Passive indices are narrowly focused. The DJ­UBS index, a commonly used index by trackers, contains 19 commodities. We aim to gain exposure to at least 50 commodities.

To give some examples of commodities missed out by the DJ­UBS index which we believe are important are:

• Energy: ethanol, coal, electricity, uranium, diesel, kerosene, natural gas liquids, plastics
• Metals:  aluminum alloy, lead, tin, platinum, palladium, steel
• Agriculturals: rice, barley, canola, oats, paper, wool, lumber, rubber, natural oils (palm, coconut, sunflower), cocoa, rubber
• Markets connected to commodities: shipping rates, weather and emissions

Moreover, the major indices focus on US-traded commodity futures ­16 of the 19 commodity futures tracked in the DJ­ UBS index are based on US exchange contracts. We look to gain exposure to commodities across different regional commodity exchanges, rather than focus solely on the US exchanges.

We believe that this approach to broadening the commodity universe provides more opportunities to boost returns but also to lower risk. Unlike equity and bond markets, commodities have low correlations with one another. Simply put, there is little reason for lead prices to be correlated to soybeans, which cannot be said for major companies within the large capitalisation equity indices.

Commodity Indices Use The Commodity Future Nearest To Delivery

This means that passive indices may miss opportunities when current prices are stable but longer­-dated prices are rising. If we take aluminum as an example, prices for delivery in the longer term (more than two years ahead) have risen faster (or fallen less) than short­-term prices (for delivery in 3 months) in 53% of months since 1993.[ii] In some cases, while current demand may be amply covered by existing stocks, the balance between long­term supply and demand may be changing significantly, which pushes up longer dated prices. Passive indices will miss these opportunities.

Most Trackers Are Backed By Notes, Not Commodity Futures

Most commodity trackers are backed by swaps and medium term notes, rather than commodity futures, exposing investors to a degree of counterparty risk (such as a bank). However, some commodities backed by physical holdings (with low storage costs) can work well in passive investments. At present, this only applies to precious metals such as gold and silver.

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