Understanding the Nuances of Commodity Indices

The Expert Committee on Integration of Commodity Spot and Derivatives Markets under the Department of Economic Affairs, Ministry of Finance (February 2018) had emphasised developing new products in the commodity derivatives market which cater to the needs of different stakeholders. One of such products recommended was ‘commodity index derivatives’.

Subsequently, on 18 June 2019, SEBI issued the formal notification permitting launch of futures trading on commodity indices. In December 2019, MCX launched the MCX
iCOMDEX series of indices, which consist of a composite index, two sectoral indices (Bullion index and Base Metals index) and four single commodity indices (indices on gold, silver, copper and crude oil). The constituents of all these indices are commodity futures traded on MCX.

Given that Indians have shown a penchant for trading in index derivatives, as best evidenced in the equity segment of Indian financial market, it is essential that nuances of commodity indices and their subtle differences from equity indices are well understood.

Excess return indices

Like equity indices, commodity indices are also computed using their constituents’ values. However, constituents of an equity index are equity stocks, whose ‘cash’ prices are used in equity index computation. On the other hand, index constituents of commodity index are commodity futures contracts, whose ‘futures’ prices are used in commodity index computation. This aspect leads to the concept of ‘rollover’ in commodity index computation, which does not exist for equity indices.

Since commodity futures contracts have a pre-fixed expiry date, it is essential that for index computation, the constituent contract is rolled over before its expiry date, to a farther month contract, to ensure continuity in index values. This effectively leads to build-up of ‘roll-yield’, also known as ‘roll return’ in commodity indices. Thus, commodity indices values not just comprise of price returns – stemming out of price movement in commodity futures prices,- but also roll returns. Hence, commodity indices are also called ‘excess return’ indices.

Rollover logic

The roll over from one contract expiry to another is usually done in a gradual manner. MCX iCOMDEX indices follow a 2-day rollover period. For sectoral indices, such as the MCX iCOMDEX Bullion and Base Metals indices, the roll over is immediately prior to the beginning of staggered delivery period of the underlying constituents.
The rollover weight is 50% each day so that on 1 st day of rollover, 50% of positions are moved from front expiry month to the immediate next expiry month, followed by movement of remaining 50% of positions on 2 nd day of rollover. Thus, by end of 2-day rollover period, index computation gradually moves from front expiry month to the immediate next expiry month.

The rollover logic for MCX iCOMDEX indices has been decided such that the rollover period coincides with the period of high liquid for the constituent commodity futures contract. This can enable cost efficient rollover of positions for index-bench marked investments in commodity futures market.

Constituent weightages

The assignment of constituent weights is another area of difference between equity indices and commodity indices. Following SEBI guidelines, commodity index constituents are assigned weights based on ‘liquidity value’ i.e. turnover on the exchange, as well as ‘production value’, i.e. deliverable supply of the commodity in the country. Thus, unlike equity indices, whose weights are based on free float market capitalization and hence computed using variables from exchange platform itself, constituent weights of MCX iCOMDEX indices are based on variables from the exchange platform (i.e. liquidity value) and outside of the exchange platform (i.e. production value).

However, given that trading trends on exchange platform reflects trading interest in the commodity, a higher weightage of 75% is accorded to ‘liquidity value’ and the balance 25% to ‘production value’ for constituent weight determination of MCX iCOMDEX indices. These weights are annually rebalanced to appropriately reflect changing market trends.

Moreover, unlike adjustments required for corporate actions in case of equity indices, no such adjustments are required in case of commodity indices. Commodities now a mainstream asset class While commodities have always been known to play the role of diversifier in a portfolio, the increasing volatility in various asset classes in recent times has only enhanced the attraction of commodities as an asset class.

However, a general concern among the investor community is that investing in commodities is not only complex but also risky given the physicality of commodities and need for necessary skills in managing them.

Commodity indices can help assuage this concern. Commodity indices enable easy investing in commodities either through trading in index derivatives or participating in ETFs/funds based on indices, without bothering about the physicality or delivery of commodities. When MCX iCOMDEX Bullion index launches, such a door for investing in one popular commodity segment has now opened up.

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