Banks launch new commodity indexes

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A number of next-generation commodity indexes have been launched in recent months, as dealers look to tap into strong investor interest for rules-based commodity investments. BNP Paribas and JP Morgan both launched new indexes in November that look to take exposure along the entire futures curve rather than being constrained to the front-month contract.

The two indexes join competing products from Lehman Brothers and UBS, which launched similar indexes last year. By being able to hold futures with different maturities, the indexes can reduce the effect of the negative roll yield in contangoed markets, the banks claim.

Traditional indexes, such as the Standard & Poor's (S&P) GSCI and Dow Jones AIG, typically hold the front-month futures contract, then roll into the subsequent contract as it nears expiry. When a market is in contango (an upwardly sloping term structure, where spot prices are lower than forward prices), the index takes a small hit on each roll. This can add up to quite a sizeable effect on performance, say analysts.

In 2006, for instance, the West Texas Intermediate (WTI) excess return sub-index of the S&P GSCI lost 20.8%, partly due to the negative effect of the roll as a result of contango in the oil markets. In contrast, the JP Morgan Commodity Curve Index (CCI) WTI sub-index lost 11.1% over the same period according to back-tests.

While each of the indexes has a similar aim - to give greater flexibility and diversity than traditional indexes - the way the various products are structured differ, in terms of the number of underlying futures contracts, how far out on the curve they go, and the criteria used to weight the various commodities. This has contributed to varying returns between the indexes.

The Lehman Pure Beta Index, for instance, rose 27.12% between January 3 and December 6, 2007. That compares with 20.84% for BNP Paribas' Commodity Market Representative Index (CMRI), 17.92% for JP Morgan's CCI, and 17.15% for the UBS Constant Maturity Commodity Index. The Dow Jones AIG and S&P GSCI, meanwhile, returned 10.51% and 26.19%, respectively.

The Lehman Brothers product invests in futures contracts out to one year, which means the index can avoid negative roll costs in contangoed markets without sacrificing liquidity, says Matthew O'Connor, head of commodity index sales at Lehman Brothers in New York. "Moving out the curve solves some of the negative roll yield issues that have dampened the return of first-generation indexes, but sacrifices the potential volatility that investors should seek," says O'Connor, adding that investing in contracts too far out the curve is "like picking up pennies in front of a steamroller" because liquidity can change quickly.

BNP Paribas' CMRI, meanwhile, goes out to two years. Lionel Semonin, global head of commodity investor derivatives at BNP Paribas in London, argues that several commodities - in particular, Brent crude and WTI - are sufficiently liquid beyond 12 months. Open interest of WTI oil futures on the IntercontinentalExchange with a December 2009 expiry was 50,983 contracts as of December 7, 2007.

The BNP Paribas product also differs in the number of underlying futures contracts that make up the index - 116 referenced to 25 constituents covering energy, metals and agriculture. That compares with 33 exchange-based single commodities for JP Morgan's CCI, 28 for the CMCI and 26 for the Pure Beta Index. By referencing a high number of futures contracts, Semonin says the index is able to take exposure to certain commodities at different maturities - there is an average of 4.64 contracts per underlying - increasing the diversity of the product: "If you move into commodities for diversification purposes, you don't want to be concentrated in a sector. Concentration can play as an advantage when the market is bullish in that commodity, but there is a price to pay when the market turns around."

Banks expect to see continued interest in these new indexes in 2008, and they are marketing a variety of structured products referenced to them. However, not everyone is so keen on the idea. "We are not pushing for one index for all our clients. We design on demand and shift from one index to another," says Christophe Cordonnier, a Paris-based director in the commodities structured derivatives group at Societe Generale Corporate and Investment Banking. "Ideally, you would want to design an index that could work all the time, but that would be nuts. It would require active management and we are on the passive side."

- Jayne Jung.

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