S&P’s flawed indexing methodology spills over risk into the commodities markets.
If you are an investor seeking commodities exposure because you understand that an inflationary world means allocation to commodities, you are in for a big surprise. Out of the $153 trillion total global assets, only $18 trillion represent alternative asset classes like PE, Real Estate, Hedge Funds, Infrastructure, Natural Resources, Commodities, and private debt. Natural Resources and commodities own 6.7% of this pie, which means just about $1 trillion of the total global assets. And if we take timber and farmland out of this small share, commodities are barely 0.5% of the big pie.
Source: CAIA Association, Portfolio for the future
The big surprise is not the lack of investing instruments but that the few instruments that allow investors to invest in commodities have an Oil problem. The commodity markets also follow Laspeyres' 1871 method, now the S&P method, which weights components based on market capitalization. The method is biased, concentrated, not passive, and hence risky. When you go shopping for commodities for asset allocation, you are not buying a group of commodities, but simply Oil, which constitutes more than 60% of the total weight of the popular ETFs you want to buy.
The reason for such a skew is that commodities have historically used the production-weighted method to build the benchmarks i.e. if a commodity contributes most to the global GDP, it gets the most weight in the index. And since Energy is a major input to the world economy, it gets the most weightage in the Index. This might sound intuitive and correct, but there is an intrinsic problem with this approach.
First; Overweighting Oil and making the commodities basket look like Oil is a poor representation of the commodity basket
Second; Concentration in Oil makes the commodity complex experience the volatility of Oil. If Oil crashes, the asset class crashes with it, and vice versa. Oil has different characteristics compared to Precious Metals, Industrial Metals, and Agricultural commodities.
Oil has different characteristics compared to Precious Metals, Industrial Metals, and Agricultural commodities.
Third; Production biased indices work may work well as economic indicators but that does not make them an appropriate investable design for driving ETFs for retail investors. Think about it, should an investor load on more Oil because the world’s GDP is becoming more fossil-fuel dependent?
Fourth; Food and Metals even if they have an underlying energy need are essential components of the current Information Age and for the sustainability of our economic life. Higher food prices are less inelastic and hence more disruptive to our social fabric compared to higher Oil, which has alternatives and consumption buffer, as we saw in COVID times.
Fifth; The mean varying nature of commodities works in conflict with the production weighted approach of the commodity Index. From a biased perspective, something that is negatively or low correlated with equity as an asset class should have different factors and biases driving it rather than the conventional drivers observed in equity.
S&P Indexing is built on a calculation convenience rather than a consistent method. Index mathematics has been long relegated by practitioners to obscurity, because bringing back purity, integrity, and representation to the Indexing domain, requires us to reboot the whole system, at a significant cost for the asset managers. You rather continue to rent a cash-flow-generating skyscraper than bring it down because it’s structurally weak.
You rather continue to rent a cash-flow-generating skyscraper than bring it down because it’s structurally weak.
Commodities Indexing, as understood by the industry is based on the flawed market capitalization production-weighted method. There is a future market derived from the underlying Index. Institutional players assume they are on the better side of risk. There are a host of other related Risk Premia Indices. And if this was not all enough, there are 10s of ETFs, repackaging the same flawed concentrated design with fees, creating instruments for institutional and individual investors to have more and more Energy biased exposures rather than a diversified commodity index.
iShares S&P GSCI Commodity-Indexed Trust holdings
As an investor, asset manager, and advisor, you should question the integrity of your investment vehicles as you question the contents of the processed foods you eat or forever chemicals [PFAS] that affect your life. Financial innovations that don't address foundational challenges will always be detrimental to investors’ long-term wealth and capital market integrity.
Financial innovations that don't address foundational challenges will always be detrimental to investors’ long-term wealth and capital market integrity.
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