Factor Model Index for Commodity Investment

Abstract

In this article the authors propose an appropriate commodities benchmark for pension funds. Commodity investment, like traditional investment, requires suitable benchmarks for performance measurement and attribution. Investing in commodities as an asset class has increased dramatically as a result of financialization. It is typically conducted by pension funds through the futures market. The tools to implement and benchmark the success or failure of such an investment strategy are still in their infancy. The authors argue that factor model indexes (FMIs) are a viable alternative to existing production-based indexes that make use of futures contracts. Using principal component analysis, they identify five factors related to grains, meats, industrial metals, energy, and precious metals. They suggest that FMI benchmarks constructed using such an approach would allow commodity investors to better measure their investment objectives.