CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

26.8 PERFORMANCE ENHANCEMENTS OF ENHANCED COMMODITY INDICES

A variety of enhanced commodity indices are available, which claim to provide return improvements over the first generation of commodity indices without increasing risk. As discussed earlier, enhanced commodity indices may be able to enhance returns by increasing weights to commodities that have recently performed well and underweighting commodities that have recently performed poorly, to capture short-term momentum. They may also seek to maximize roll return by increasing weights in commodities that are in steep backwardation and by underweighting those in steep contango. Furthermore, they could gradually roll their futures contracts or utilize longer-maturity contracts to minimize the price impact of their roll activities or reduce volatility. Unfortunately, validating the performance improvement due to the methodology enhancements of these indices is far from trivial. As Erb and Harvey (2006) point out, commodity futures markets tend to exhibit high volatility and very low correlations with one another. As a result, the returns of commodity indices have been driven by a few commodities that historically performed extremely well. This makes ex-post comparisons between index methodologies difficult, since a high weight in a commodity that happens to perform extremely well can have a large impact on returns.

To analyze the potential improvements of enhanced commodity indices while addressing this issue, Fuertes, Miffre, ...