Commodity Index – Meaning and How it Works?

A commodity index is an alternative investment vehicle that tracks the prices and returns on investment of a basket of commodities. It tracks currencies, agri commodities, energy products, precious metals, industrial metals, etc. The value of the index depends on the fluctuations in the underlying commodities. In India, the Multi Commodity Exchange of India Limited (MCX) is a popular commodity index that tracks commodity ETFs.

What is the commodity index?

A commodity index is an investment vehicle that tracks the prices and return on investment of a basket of commodities. It measures the price of physical commodity or price on the commodity in the futures contract on a commodity exchange.

It is often traded on the trading platform. Investors seeking access to commodities markets without entering into the futures market invest in these indexes.

The value of the index fluctuates on the basis of the underlying assets. They vary by the way they are weighted and commodities that form a part of it.

Similar to equity indices, even these consist of instruments that trade on the exchange platform. However, the commodity index constitutes future contracts, while the equity index constitutes cash equity scrips.

Each index is different in terms of the number of goods it consists of. They also differ on the basis of the weights of different commodities. The underlying asset can be a commodity or a combination. But, they are not necessarily equal in weights.

In India, the first tradable commodity index, MCX iCOMDEX, was launched in 2019. MCX iCOMDEX is the first tradable commodity index series in India. It represents all the sectors of the commodity markets.

The MCX iCOMDEX indices have future contracts traded on MCX. The index family consists of the following:

• A composite index consisting of eleven commodity futures across different segments trading on MCX.
• Two sectoral indices (Base Metal Index and Bullion Index), constituting base metals and bullion futures trading on the MCX.
• Four single commodities (silver index, gold index, crude oil index and copper index), constituting futures of the respective commodity futures trading on the MCX.

How does the commodity Index work?

A commodity index is an alternative investment vehicle that tracks the prices and returns on investment of a basket of commodities. It measures the price of physical products. It is an index that tracks prices of items such as corn, wheat, coffee, cocoa, sugar, soybeans, precious metals, cotton, palm oil, crude oil, natural gas, gold, silver, copper, industrial metals, etc. Every commodity index differs in terms of the number of goods it tracks, the weightage of the products, and sometimes the number of commodities. For example, there are indexes that track just one commodity like MCX iCOMDEX Base Metals Index, which tracks only metals.

The value of the index depends on the price of the underlying assets. Any fluctuations in the underlying assets will impact the value of the index. An investor who doesn’t want to invest in future prices of commodities can invest in a commodity index. The investors benefit from capital appreciation rather than interest or dividends. When the price of the underlying asset increases, the investor gains from capital gains.

Commodities are raw materials that everyone uses. For example, the gas filled in a car, the food one eats, the cotton shirt one wears, all these interact with the commodities exchange at one point.

The commodities exchange sets the prices or at least influences the prices of many goods. Individuals and companies around the globe use goods.

Commodity index first started in 1993 when Dow Jones futures index first started to track commodity prices. Commodity investing has gained popularity after oil prices started increasing from the historical $20-$30 per barrel range in the early 2000s. At the same time, Chinese industrial production went up, raising the prices of commodities. This, combined with limited global supply, has led to an increase in the prices of commodities, gaining the attention of investors.

In India, MCX (Multi Commodity Exchange of India Limited) is the first listed commodities derivatives exchange. It facilitates online trading of commodity derivatives. It was established in the year 2003 and is regulated by SEBI. MCX recently launched MCX iCOMDEX. It consists of indices that are created from futures contracts trading on MCX. The MCX iCOMDEX family consists of a composite index, two sectoral indices and four single commodity indices.

How is the commodity index different from other indices?

Commodity index differs from other indexes. The total return of the from it is completely dependent on the capital gains, or on the price performance of the commodities. Following are the unique characteristics of the commodity index:

Construction of commodity indices often follows unique principles. For example, some take into account the physical market size of the commodities. The market sizes across the country help in determining the weights of index constituents.

Each constituent contract of a commodity index has a definite life. Therefore, expires at the end of its life. Hence, for the continuity of the index, the constituent’s contracts are ‘rolled over’. Rolling over helps in changing the expiry from one date to another future date. Also, the rollover happens only on pre-decided dates. These dates are known as ‘rollover days.’

The constitute contracts usually rollover between two expiries. The index here captures the difference between the returns of the two expiries. Therefore, such a difference gives an opportunity to earn ‘roll return.

Roll return is the excess return that is over and above the return from price movements of the constituent commodities.

The trading platform sets the prices or at least influences the prices of many goods. Individuals and companies around the globe use goods. Therefore, changes in commodity prices can have an impact on the entire segment of the economy. Furthermore, these changes can, in turn, spur social and political action. For example, political actions like subsidy and tax changes or policy shifts. Social actions like, supply and demand, substitution for the commodity, change in industrial production, or new innovations. The commodity index is one way to track the price changes of the items.

Also, for most investments, cash receipts such as interest, dividends and capital gains are the measure for total returns. At the same time, commodities do not pay interest or dividends. Therefore, an investor is completely dependent on capital gains. For example, if the price of the commodity does not go up, the investor has a zero return on their investment.

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