Third generation commodity indices and effectiveness of financial investments in commodity markets

Abstract

Financial products based on commodity indices have become a favourite tool for gaining exposure to commodities markets by financial investors. During the early years of the century these indices evolved to better represent real market investment strategies. The most significant development is the introduction of the 21st so-called third generation commodity indices. Their main new feature is the inclusion of an active element of portfolio construc- tion. Empirical analysis has shown that during the period of 2008-2012 third generation indices have managed to generate superior investment performance in terms of returns and risk characteristics as compared to traditional commodity indices or stock indices. It has to be noted, however, that these new indices represent a significant departure from the traditional passive approach to commodity investing and are in fact actively managed investment portfolios, whose performance rely to a large extent on the quality of investment prowess of the institution responsible for index calculation. The main driving force, behind the evolution of commodity indices construction, were the needs of portfolio financial investors which might be interpreted as another sign of commodity markets financialization. However, it has to be noted that these new indices do not replace the traditional first generation indices but they are being published simultaneously. Shifting activities of portfolio inves- tors into these new indices may eventually help traditional indices better serve their primary role as commodity market price indicators.