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INTELLIGENT COMMODITY INDEXING
A PRACTICAL GUIDE TO INVESTING IN COMMODITIES
By Robert J. Greer, Nic Johnson, Mihir P. Worah
The McGraw-Hill Companies, Inc.Copyright © 2013Robert J. Greer, Nic Johnson, and Mihir P. Worah
All rights reserved.
History of Commodity Indexing
There has been an interest in commodity prices, and indexes of those prices, for a very long time. Until the late 1970s, those indexes typically referred to prices of physical commodities. Part of the reason is that the interest in commodity prices stemmed from the impact that commodities had on the overall economy, whether in the United States or elsewhere. Commodities were not typically viewed as an investment vehicle in their own right.
Some of those early indexes were published by Reuters, by the Financial Times, by the Economist, and by other data sources. These indexes comprised a broad range of commodities, including commodities for which there were futures markets as well as commodities that had no futures equivalent. There were, and are, a variety of other indexes of cash commodity prices for specific industries, including livestock, energy products, and mining products. Both Dow Jones and the Commodity Research Bureau also published indexes that used the current, or spot, month of commodity futures markets as a surrogate for cash markets, partly because this information was readily available. But like those other early indexes, these published indexes based on futures prices were not investable because they could not be replicated by a financial investor. Therefore if investors wanted exposure to commodity prices, they typically would purchase the capital asset that was used to produce the commodity—farmland, or a metals mine, or an oil and gas partnership, or natural resources companies. These investments could provide some positive exposure to commodity prices, but there were drawbacks.
While the most obvious problem was liquidity, an investment in the means of producing a commodity also gave exposure to other risks, not all of which were related to commodity prices. For instance, the success of a farmland investment might depend not just on the price of the food it produced but also on the weather. And the purchase of a natural resources stock exposed the investor to the financial structure of the company and to the management talent of the company. There could also be risks unassociated with the price of the commodity, as investors in BP realized when that company's oil rig exploded in the Gulf of Mexico in 2010. In this case, while oil prices initially spiked higher due to the loss of production, BP stock actually declined significantly on anticipation of liability and cleanup costs associated with the explosion.
Actually purchasing and storing a commodity in order to benefit from an increase in its price was also typically not practical, with the exception of precious metals, for which the storage cost was small relative to the value of the investment. Industrial metals might also be purchased and stored for long periods, but in this case the storage cost was a much higher percentage of the investment. Additionally, some agricultural commodities could be purchased and stored for limited periods of time, but that type of investment would suffer from spoilage as well as from high costs for storage and insurance. Furthermore, there was not a large incentive to hold commodities in order to benefit from rising prices, since the prices of many commodities had not even kept up with inflation during the decades following World War II. This was partially the result of improving technology that enhanced extraction rates for oil and metals as well as increased yields for grains, resulting in periods when commodity supply, both actual and potential, was well above demand.
During the inflation and related shortages of several commodities, such as grains and industrial metals, in the 1970s, however, the interest in commodities for investment began to take root. But still, that interest tended to express itself in the purchase of the capital assets that actually produced commodities. Although the impact of higher commodity prices on inflation may have been well understood, the possibility of hedging against this via a systematic investment in a basket of commodity futures was generally not appreciated. Investors were typically not able to get exposure to anything like a broad-based index of commodity prices.
THE FIRST INVESTABLE COMMODITY INDEX
The early 1970s was also a time when investors first saw the idea of an investment designed to replicate an index of the stock market. Sure, there had been stock indexes for many, many years, but the first stock index fund was not offered until the early 1970s. Seeing that commodities were contributing to inflation in the 1970s, and seeing also the appearance of an investable stock index fund, gave Bob Greer the idea of finding a way for a financial investor to gain exposure to commodity prices. At that time, commodities were thought of as high-risk investments. But in fact, the price of an individual commodity may often be no more volatile than the price of a single stock. The price of wheat was typically no more volatile than the price of IBM.
There were two reasons why commodities were thought of as being so risky. The first reason was that participants in the commodity futures markets typically used a large amount of leverage. This leverage was possible because the market participants did not actually own a physical commodity, which would have required borrowed money to finance. Instead, the market participants made a commitment to buy (or sell) a commodity in the future. As long as they closed their position before they were contractually obligated to take delivery of (or deliver) the physical commodity, they only had to deposit sufficient margin to ensure that they could perform on that future commitment, adjusting that margin as the price of the future commitment moved for, or against, them. This allowed the market participants to be exposed to a large notional amount of the commodity with only a small capital commitment. Hence small adverse movements in the price of commodities could entirely wipe out the capital of these levered investors, just as small favorable moves might multiply the investors' capital manyfold. This margin deposit might be thought of as being similar to the earnest money deposit that is typically made by a buyer of a house when that house is put under contract. The full amount of the purchase price is only required when the sale is consummated. This leads to the second reason that commodity investment was misunderstood. Many investors did not understand the very nature of a futures contract. They equated having a long position in a commodity futures market with outright ownership of the commodity itself.
To take the risk of leverage out of a commodity investment, it was possible to fully collateralize the commodity contract. That is, if a live cattle contract (40,000 pounds) were trading at 50 cents per pound, the notional value of the contract would be $20,000. Instead of making a minimum margin deposit of, say, $1,000, investors could allocate a full $20,000 of their portfolio to support a single long contract in cattle. The investors thus would have the capital actually to purchase the cattle if these investors chose to do so. The notion of leverage is removed, because no matter how low the price of cattle might fall, the investors would have money to meet any margin call. And the investors' total return would be the return on collateral plus or minus the change in the price of the futures contract. This idea meant that the investors would always have positive exposure to a rising cattle price. It also meant that full collateralization could only take place with long positions—you can't determine how much collateral would be required to support a short position, since there is no way of knowing the maximum size of a move against you.
Excerpted from INTELLIGENT COMMODITY INDEXING by Robert J. Greer. Copyright © 2013 by Robert J. Greer, Nic Johnson, and Mihir P. Worah. Excerpted by permission of The McGraw-Hill Companies, Inc..
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