The S&P GSCI™ is world-production weighted; the quantity of each commodity in the index is determined by the average quantity of production in the last five years of available data. Such weighting provides the S&P GSCI™ with significant advantages, both as an economic indicator and as a measure of investment performance.
For use as an economic indicator, the appropriate weight to assign each commodity is in proportion to the amount of that commodity flowing through the economy (i.e. the actual production or consumption of that commodity). For instance, the impact that doubling the price of corn has on inflation and on economic growth depends directly on how much corn is used (or produced) in the economy.
From the standpoint of measuring investment performance, production-weighting is not only appropriate but vital. The key to measuring investment performance in a representative fashion is to weight each asset by the amount of capital dedicated to holding that asset. In equity markets, this representative measurement of investment performance is accomplished through weighting indices by market capitalization.
For commodities, there is no direct counterpart to market capitalization. The problem is that commodities, and the related price risks, are held in a variety of ways – long futures positions, over-the-counter investments, long term fixed-price purchasing contracts, physical inventory at the producer, etc. – making a complete accounting of capital dedicated to holding commodities from the time they are produced to the time they are consumed infeasible. A simple way to achieve a close analog to true market capitalization, abstracting from differences in inventory patterns, is to note that the net long position of the economy is proportional to the quantity produced; hence, production weighting.
A Broad Spectrum of Commodities
The S&P GSCI™ contains as many commodities as possible, with the rules excluding commodities only to retain liquidity and investability in the underlying futures markets. Currently, the S&P GSCI™ contains 24 commodities from all commodity sectors: six energy products, five industrial metals, eight agricultural products, three livestock products and two precious metals.1 This broad range of constituent commodities provides the S&P GSCI™ with a high level of diversification, both across sub-sectors and within each sub-sector. This diversity minimizes the effects of highly idiosyncratic events, which have large implications for the individual commodity markets but are muted when aggregated to the level of the S&P GSCI™.
Together, the diversity of its constituent commodities and their economic weighting allow the S&P GSCI™ to respond in a stable way to world economic growth, even as the composition of global growth changes through time. When world growth is dominated by industrialized economies, the metals sector of the S&P GSCI™ generally responds more than the agricultural components. Similarly, when emerging markets dominate world growth, agricultural and petroleum-based commodities generally respond the most. Thus, for example, an index that significantly underweights agriculture would significantly underperform in a global economy with weak OECD and strong emerging markets growth, much as a stock index that only contained industrials would provide a misleading picture of a service-led economy.
1 As the GSCI transitioned from including Unleaded Gasoline to including RBOB Gasoline, the GSCI contained 25 commodities, 7 of which were in the energy sector. This transition period lasted from the August 2006 roll to the October 2006 roll.
Liquidity Constraints for Inclusion and Return Calculations
Individual commodities are screened by liquidity for inclusion in the S&P GSCI™. The eligibility requirements are designed to promote cost-effective implementation and true investability. Underlying liquidity eases hedging of derivative products and investing in sub-sector or individual commodity overlays. Furthermore, liquidity in the underlying futures markets facilitates the discovery of true market prices for the components of the S&P GSCI™.
S&P GSCI™ returns are calculated (discussed in detail in the following section) based on the arithmetic average of stable long positions in futures contracts. This methodology, along with the liquidity in the underlying markets, allows easy implementation of the portfolio of futures contracts that the S&P GSCI™ represents. These characteristics of the GSCI are designed to allow for efficient and relatively inexpensive arbitrage of publicly traded S&P GSCI™ related instruments such as the CME futures contract.