What is commodity index re-balancing?

Every year around this time, the world’s commodity index managers go through the annual rite of re-balancing their mix, shifting ratios that can swing billions of dollars from one market to another. These mammoth products, which now boast hundreds of billions of dollars worth of funds after growing from nearly nil a decade ago, follow fairly clear formulas for deciding whether to add or subtract oil, wheat or copper from their plan.

The re-balancing typically requires selling contracts that have appreciated the most during the year, and buying those that have under-performed, in order to return to the set targets. Re-balancing typically occurs in January during a five-day business period. Other funds re-balance monthly or use different systems that avoid big shifts during the January roll period.

Based on 2018 year to date performance, the re-balancing would likely require selling star performers like wheat and Brent / WTI crude oil, and the purchase of downtrodden markets like sugar and zinc. Given the current large net short position in the futures market, sugar prices have perhaps the greatest potential to see a rebound, should the indexes be forced to buy.

Not something to necessarily preempt but to be aware of. The re-balancing is signaled well in advance and of course everyone in the market has some idea of how the re-balancing works too.

What is a commodity index?

A commodity index either invests in or tracks the performance of a group of commodities based on predefined rules. It is often the performance of these indices that is referred to in the media or when comparing commodity performance with other markets, such as stocks and bonds. Large investors often prefer a diversified approach, especially to commodities, given the high level of volatility that invariably goes with investing in individual commodities. Commodity index funds help investors to properly benchmark the performance and return of their investments.

The two major indices, as mentioned above – the S&P GSCI index and the Bloomberg Commodity index – have become the industry-standard benchmarks for investors in commodities. Investors either invest directly into the funds or through exchange-traded funds that track their performances. Furthermore, many local commodity fund offerings track one of the two commodity funds.

The S&P GSCI, established in 1991, is an index calculated primarily on a world production-weighted basis. It includes 24 physical commodities that are the subject of active, liquid, futures markets. The weight of each commodity in this index is determined by the average quantity of production and is designed to reflect the relative significance of each of the included commodities to the global economy. Based on this indexing the S&P GSCI is very heavily exposed towards the energy sector.

The Bloomberg Commodity Index (BCOM), previously called the DJ-UBSCI was established in 1998 and has a more diversified approach. This index comprises 22 physical commodities, all represented by active futures markets. No single commodity can comprise less than 2% or more than 15% of the index and no group or sector can represent more than 33%. The weightings for each commodity included are calculated in accordance with rules designed to ensure that the relative proportion of each of the underlying individual commodities reflects its global economic significance and market liquidity.

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