This is not to be confused with the equal-weighted ETF which has created a lot of buzz in recent months. Equal-weighting commodities can be risky because you are investing in assets that may have been undervalued or overvalued for extended periods of time, but this method does have its benefits and should not be ignored altogether. In general, it’s good to diversify your portfolio with both low-risk and high-risk investments so as not to lose all your money when one investment tanks.
What is the Equal-Weighted Commodity Index
The equal-weighted commodity index is a portfolio of futures contracts on commodities that are equally weighted. It takes the price of multiple commodities and calculates an average, then buys all those assets in proportion to their value, which can be done because the prices are quoted in dollars per unit so it’s as easy as dividing by the quantities purchased.
This is a way to diversify your assets across multiple sectors of the economy and give you access to an asset class that isn’t readily available in typical portfolios.
How is the Equal-Weighted Commodity Index Calculated
The equal-weighted commodity index is calculated by taking the current price of each asset and dividing it by its average historical value, then multiplying that result by the quantity purchased. An example of how this is done can be seen below:
(Brent Crude Oil Price / Average Historical Price) * Quantity Purchased = Weighted Average Price
For example, if you have a current price of $100 and an average historical value of $80, then:
(100/80) * 5 = $125
This means that for every dollar invested, you would receive four dollars’ worth of oil. There is some inherent risk in this strategy because the high-risk commodities will make up a greater portion of the portfolio. So if gold and silver prices skyrocket, your portfolio will be heavily weighted in those assets which could become dangerous if they were to suddenly crash.
However, this is not a bad strategy because you should have a diversified portfolio anyway. It gives you access to an asset class that would normally only be available to institutional investors, at least to a limited degree.
How does the Equal-Weighted Commodity Index compare with other indexes
It has been shown that commodities tend to rise when equities are falling, and vice versa. However you should be cautious about investing in commodities because they are much more volatile than stocks, so there is a greater chance that you’ll lose a lot of money in them if the prices plummet.
In addition, investing in commodities is not as liquid or simple as trading stocks because most indexes are value-weighted and therefore only take into account the current price of each asset, not its average historical value.
Advantages and Disadvantages of Equal-Weighted Commodity Index
The Equal-weighted Commodity Index comes with both advantages and disadvantages.
Advantages
- All commodities in the index are equally weighted so you can diversify your portfolio in this asset class.
- Some indexes are value-weighted which means that they only take into account the current price of each commodity, but with equal weighting, you’ll have greater exposure to historical performance and won’t be able to form a judgment about whether the commodity is overvalued until you do a comprehensive analysis of its historical performance.
Disadvantages
- The equal-weighted index is much more volatile than the value-weight indexes because it has more exposure to commodities that have been extremely volatile in the past. So if you invest heavily in this option, there’s a good chance you’ll lose a lot of money.
- It’s difficult to create an index that is diversified because most commodities tend to move in the same direction, so if you invest heavily in them, there’s a good chance they will all perform poorly and your portfolio will decline as a result.
Conclusion
Investing in the Equal-weighted Commodity Index is a great way to gain exposure to an asset class that does not represent the market as a whole. However, because commodities tend to move together and have been extremely volatile in the past, this option will likely result in your portfolio declining if you invest too heavily into it.
Further questions
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