A commodity index is an investment tool that tracks the price and the return of a basket of commodities. It can be tradable or used just for reference purposes. It enables an investor to gain access to the commodity market without actually entering individual commodity futures.

Why trade in commodity indices?

Market indices are fit for all types of participants. They are one of the best investment options for investors, as they reflect the overall performance of a basket of individual constituents.

Here are some other important things to know about commodity indices:

Investing in commodities can enable market participants to achieve portfolio diversification and hedge against inflation.

Investors may experience volatility when exposed to a single commodity or one sector. However, an index is a basket and therefore, it mitigates that risk.

An index gives investors the option to trade multiple commodities through one contract.

Indices are settled in cash and do not lead into physical delivery like individual commodities.

The margin for trading indices is lower compared to individual commodities.

Are there any popular commodity indices in use today?

Just like equities have some popular indices like the Dow Jones, the S&P 500, and the Nifty50, commodities have their own benchmarks, such as the Bloomberg Commodity index and the Thomson Reuters CRB index. The S&P Goldman Sachs Commodity Index (S&P GSCI) is the most tracked index in the commodity market; it has the most funds following, or tracking, its performance. The value of an index depends on the price of its underlying assets.

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On the domestic front, there are three popular commodity indices that are in use today:

MCX Bulldex: The index comprises around 70 percent gold and 30 percent silver.

MCX Metldex: It is a basket of five actively traded base metals on MCX with different weightages.

MCX Enrgdex: It comprises two-thirds crude oil and one-thirds natural gas.Besides, there are two other commodity indices: the Ncdex Guardex and the Soydex. Both are based on agri products.

Currently, there is only futures contract available for trading on the commodity indices. We believe that the market will expand well once there are options (derivatives) introduced for these indices.

How does a commodity index differ from other indices?

Commodity index vs equity index

Similar to equity indices, commodity indices can be traded on exchanges. A major difference between the two, however, is that the underlying asset in case of a commodity index is a future contract, and cash equity in case of an equity index. The value of the index fluctuates on the basis of underlying assets.

The total return of a commodity index is entirely dependent on capital gains or the price performance of commodities. A commodity index works on a unique set of principles. It takes into account the size of of the physical commodity market size, which helps in determining the weights of index constituents. Each constituent contract of a commodity index has a definite life, expiring at the end of the cycle. For the continuity of the index, the constituent contracts are rolled over on pre-decided dates.

The index captures the difference between the returns of the two expiry dates, which earns a rollover return, which is the excess return over and above the return from price movements of constituent commodities.

On the domestic front, the MCX Bulldex and the MCX Metldex are the most actively traded indices. We believe there is immense potential in these commodity indices in comparison to equity indices such as the Nifty and the Bank Nifty. With the recent volatility in metals, crude oil and natural gas, these indices offer an extra cushion to traders than individual commodities.

-- Navneet Damani is VP-Commodity Research at Motilal Oswal Financial Services. The views expressed in this article are personal.