Comparing First, Second and Third Generation Commodity Indices

Abstract

The rising interest of institutional investors for commodities since the early 2000s prompted remarkable financial engineering in the commodity index space which is now in its third generation. The purpose of this article is to review this evolution and to give an assessment of index performance. Long-only second generation indices, which attempt to minimize the harmful impact of contango on performance and use active long-only signals based on momentum or roll-yields, are found to outperform their first generation counterparts. Third generation indices fare even better as they accurately buy backwardated assets and short contangoed ones, thereby reducing overall volatility. We see these indices as serious contenders to commodity trading advisors that merely replicate strategies based on momentum or term structure.