All Index Funds Aren’t Created Equal

05/17/2007 12:00 am EST

Focus: MARKETS

Ivan Martchev

Editor, Vital Resource Investor and Global Viewpoints

Ivan Martchev, editor of Vital Resource Investor, takes a look at how indexes are calculated and picks a fund that offers the most representative way to invest in commodities.

How is it possible to have an all-time high with only 13 stocks in positive territory since the last one?

The Dow Jones Industrial Average is a price-weighted index; the higher the price of the stock, the greater its weight. IBM, trading at approximately $100 a share, is the heaviest-weighted stock. Intelis the cheapest at just over $21. A one-dollar move in IBM or Intel would produce the same effect on the Dow, even though such a move would be much bigger on a percentage basis for Intel than for IBM.

The Standard & Poor's 500, the most important benchmark, is a market-cap-weighted index. A one-dollar move for Intel is worth a lot more than a one-dollar move for IBM. Because the calculation is a bit more rational, most prefer the market-cap method of weighting an index.

But no system is perfect. The S&P 500 is dominated by the largest components, so in a way, as the top 50 stocks go, so goes the index. Investing in an index fund that tracks the S&P 500 is like investing in those 50 stocks, which never seem to make much progress.

The massive outperformance of the equal-weighted S&P 500 over the market-cap-weighted S&P 500 shows that small- and mid-cap stocks have been the place to be in this bull market.

When Reuterstook over the Commodity Research Bureau (CRB) CRB, the company also introduced the Reuters-Jeffries CRB index, which is no longer equally weighted [as the old CRB index was]. The new index is marketed to institutional investors for use in futures index funds.

The move was probably prompted by the loss of significant ground to Goldman Sachs, whose commodity index (GSCI) has become the commodities market's equivalent of the S&P 500. The Goldman Sachs Commodity Index (GSCI) is the index with the most money behind it, [and] the more trading activity in a particular commodity, the greater the weight [of that commodity] in the index. That causes the energy sector to have an unbelievable 69% weight in the index.

The best way to follow the commodities markets with an index fund is through the Dow Jones-AIG Commodity Index. The components aren't equally weighted, but the individual categories are. Energy comprises about a third of the index, metals account for another third, and soft commodities are the final third. The individual commodities are then weighted within their respective sectors.

PIMCO Commodity RealReturn (PCRDX) follows the Dow Jones-AIG Total Return Index. Total return simply means that the collateral for the investments in commodities is then invested in interest-bearing securities. This adds an extra return kicker. The straight Dow Jones-AIG Index returned 4.6% in the first quarter, while the PIMCO fund returned 5.4%.

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