## **Learning Outcomes**

This article explains how major commodity indices are constructed and maintained, emphasizing the rules that determine constituent selection, contract choice, and sector weightings. It clarifies how production- and liquidity-based weighting schemes shape index exposures, with particular attention to the dominance of the energy sector in many popular benchmarks. The article details the mechanics of rolling futures contracts, contrasting different roll schedules and contract-selection approaches, and examines how contango and backwardation translate into positive or negative roll yield. It analyzes the three components of total return in fully collateralized commodity index strategies—collateral return, price return, and roll return—and illustrates how these interact over time using focused numerical examples. The article also reviews how rebalancing frequency and methodology affect index behavior, tracking error, and risk characteristics relative to spot commodity prices. Finally, it discusses the practical uses, benefits, and limitations of commodity indices as tools for diversification, tactical asset allocation, and inflation hedging, highlighting concepts and exam-style questions that are frequently tested at the CFA Level 2 exam.

## **CFA Level 2 Syllabus**

For the CFA Level 2 exam, you are expected to understand how commodity indices operate as investment vehicles, their construction, and the sources of return and tracking error relevant to commodity exposures, with a focus on the following syllabus points:

- Explain the components of total return in fully collateralized commodity index strategies
- Compare alternative commodity index construction and weighting methods
- Assess the impact of roll schedules, contract selection, and rebalancing on index returns
- Explain the uses, risks, and limitations of commodity index investing

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What are the three main components of total return for a fully collateralized commodity index futures strategy?
2. How can the method of contract roll in a commodity index affect the index's long-term performance?
3. What sector often has the highest weight in major commodity indices, and why can this be significant for returns?
4. Explain the difference between a price return and a roll return in the context of a commodity index.

## **Introduction**

Commodity indices offer investors broad based exposure to a selection of commodities through publicly traded index products such as ETFs, swaps, or futures. The construction and methodology of these indices fundamentally shape the returns, risks, and uses within a diversified investment portfolio. Understanding the key mechanisms—including sector weights, roll schedules, and rebalancing regimes—enables effective exam preparation and real-world application.

## **Commodity Index Construction Principles**

A commodity index represents a weighted basket of futures contracts, typically spanning energy, metals, agriculture, and softs. Major indices, such as the S&P GSCI or Bloomberg Commodity Index, differ meaningfully in the commodities included, the sector weights, and the choice of calculation method.

> **Key Term: Commodity Index**
> A portfolio of commodity futures contracts that provides investors with benchmark exposure to a wide range of commodities, weighted and rebalanced according to predetermined rules.
>
> **Key Term: Sector Weighting**
> The proportional allocation to each category of commodity (e.g., energy, agriculture) within a commodity index, determined by rules such as production value or liquidity.

A common approach in index construction is to weight each commodity by its relative share of global production or global liquidity. This often results in energy commodities, especially crude oil and petroleum products, dominating index composition.

### Index Roll, Rebalancing, and Contract Selection

Most commodity indices are based on rolling front-month futures contracts forward as they approach expiry to maintain exposure. The roll schedule—the timing and process of moving from expiring to further-dated contracts—impacts returns, especially in markets experiencing contango or backwardation.

> **Key Term: Roll Yield**
> The return component from the movement or "rolling" of a futures position forward in time as a contract approaches maturity, due to the difference between current and next contract prices.

Rebalancing methods (e.g., monthly, quarterly, annually) and the particular algorithms for contract selection and weight adjustment can lead to further divergence among indices and their respective products.

### **Worked Example 1.1**

An index rolls WTI crude oil contracts monthly. In a period where the front-month contract is \$70 and the next-month contract is \$71 (contango), what is the roll return?

> **Answer:**
> Roll return = (Expiring futures price – New futures price) / Expiring price  
> = (70 – 71) / 70 = –1.43%.  
> A negative roll return arises in contango markets, reducing overall index returns.

### **Return Components of Commodity Index Investing**

Commodity index investors typically obtain exposure via futures, not physically holding commodities. The return therefore consists of three main components:

1. **Collateral Return:** Yield earned from investing collateral (often Treasury bills) equal to the notional value of futures contracts.
2. **Price Return:** Gain or loss from changes in the futures contract prices (spot return).
3. **Roll Return:** Profit or loss from rolling contracts forward, driven by the futures term structure (contango or backwardation).

> **Key Term: Collateral Yield**
> The interest earned on cash or equivalents posted as collateral to support a fully funded futures or swap position.

### **Worked Example 1.2**

A fully collateralized commodity index position uses \$1,000,000 in T-bills yielding 2% and gains 4% from price return but has a –1% roll return over a year. What is the total return?

> **Answer:**
> Total return = Collateral yield + Price return + Roll return  
> = 2% + 4% – 1% = 5%.

### **Index Weighting and Sector Exposures**

Because index weights are typically fixed by value of production or liquidity, sector exposures often fluctuate little between rebalance dates regardless of relative price changes. Energy commonly makes up 50% or more of exposure in production-weighted benchmarks (like S&P GSCI), while more diversified indices (like Bloomberg Commodity Index) impose sector caps for balancing.

This has implications during periods of major sector outperformance or underperformance, severely affecting overall index results.

### **Exam Warning**

> In the exam, do not assume all commodity indices are diversified. Many are heavily weighted toward the energy sector due to their construction methodology.
>
> Be clear whether a question refers to price returns or total returns including roll and collateral yield for futures-based strategies.

### **Practical Uses and Limitations**

Commodity indices provide liquidity and streamlined access for investors, enabling asset class diversification and hedging. However, tracking error to spot prices can arise due to structural elements—particularly roll methodology, rebalancing, and sector dominance. Negative roll yield (in contango) or positive roll yield (in backwardation) can meaningfully impact actual investor experience, distinct from spot price movements.

### **Revision Tip**

> For the exam, remember total returns for commodity indices are far more than just changes in futures (or spot) price. Roll and collateral yield matter greatly, especially over long periods.

## **Summary**

Commodity index products deliver commodity exposure using rules-based methods for weightings, contract selection, roll schedules, and rebalancing. Returns stem from three components: collateral interest, price changes in futures, and roll return (from converging futures curves). Energy sector dominance is typical in many benchmarks, affecting risk and performance.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain the construction and weighting of major commodity indices
- Identify the three key sources of return in a fully collateralized index strategy (collateral, price, roll)
- Assess how roll schedules and contract selection affect investor experience
- Recognize sector dominance and its risk for tracking error in index-based products
- Understand that commodity index returns differ from spot returns, particularly due to roll yield and weighting methodology

## **Key Terms and Concepts**

- Commodity Index
- Sector Weighting
- Roll Yield
- Collateral Yield

Commodities and real assets - Commodity indices strategies and exposures