London, 7 October 2011: Reuters

Every year around this time, the world's commodity index managers go through the annual rite of rebalancing their mix, shifting ratios that can swing billions of dollars from one market to another come January.

It is an important, but rarely dramatic, process. These mammoth products, which now boast more than $300 billion in tracking funds after growing from nearly nil a decade ago, follow fairly clear formulas for deciding whether to add or subtract oil, wheat or copper from their plan.

This year's calibrations hold more intrigue than usual, however, as they will feed into the biggest debate in the oil market in years: the growing role of Europe's Brent crude contract as an important global benchmark.

Standard & Poors could be the first to give investors a glimpse of what's coming next year when it holds a meeting on Thursday to review its S&P GSCI. The energy-heavy index was founded 20 years ago by Goldman Sachs, but sold to S&P in 2007 as demand for commodity exposure surged.

While the GSCI is still the largest of the bunch, with an estimated $100 billion tracking it, it will not be the main event. Its reweighting is based on global production of the 24 components, and as a result the GSCI index rarely fluctuates significantly. The greater focus will be on the Dow Jones-UBS Commodities Index, which also considers the liquidity of futures markets when determining how to balance its constituents.

Once the also-ran to the preeminent GSCI, DJ-UBS has significantly expanded its market share in the two years since Swiss investment bank UBS replaced bailed-out insurer American International Group as the financial partner, growing its tracking funds to reach some $80 billion by mid-year.

It must now decide whether to break with tradition by adding a second type of crude oil to the index, and it won't be alone. The Reuters-Jefferies CRB published by news and information provider Reuters and investment bank Jefferies may also add Brent to its 19 commodities.

ALL EYES ON BRENT

The ground is laid: DJ-UBS said in April that it was considering changing its rules to give it the option to add Brent, trading in which has surged as it claims a growing role as the global benchmark. And the stakes have risen since then.

By relying solely on the U.S. light, sweet NYMEX contract, which has fallen to a record discount versus Brent this year due to a glut of Midwest crude, investors have suffered an opportunity loss estimated at almost $25 billion over six quarters, according to a Barclays Capital study in July. Switching now would cause investors to realize that loss; but staying out could leave them disconnected from the more representative global contract for even longer. A New Expiry Brent contract now being introduced threatens to complicate matters further, traders say.

Giant U.S. bond investor PIMCO, whose $28 billion CommodityRealReturn Strategy Fund tracks the DJ-UBS, isn't too worried by the prospect, and believes the  IntercontinentalExchange will be able to manage the transition in Brent without losing liquidity.

"I think we're all for using whatever variety of contracts that best represent the global price of oil," Nic Johnson, commodities portfolio manager at PIMCO, told Reuters. "If that means widening the number of contracts from just WTI to include Brent, I don't think we have an issue."

Given the DJ-UBS index's current 14.7 percent weighting to WTI crude and $80 billion in funds, moving to a 2:1 WTI:Brent ratio -- similar to the S&P GSCI's mix -- would require the sale of some 49 million barrels of WTI and the purchase of 38.4 million barrels of Brent, a shift of $3.9 billion.

"Because of the difference in methodologies, the DJ rebalancing tends to have a greater impact on the market than the S&P GSCI," said Gustavo Soares, analyst at Bank of America Merrill Lynch.

"The DJ index is focused on percentage weights, which have to be readjusted each year; the S&P GSCI is focused on production weights, therefore the number of contracts it holds. So those don't vary too much year-to-year," Soares said.

The rebalancing typically requires selling contracts that have appreciated the most during the year, and buying those that have underperformed, in order to return to the set targets. Other funds rebalance monthly or use different systems that avoid big shifts during the January roll period.

Based on year to date performance, the rebalancing would likely require selling outperformers like gold and livestock futures, and the purchase of recently downtrodden markets like copper, wheat, cocoa and natural gas.

DJ-UBS will be the first to put out a full set of index components and weightings for 2012 if it sticks to last year's end-October date. Dow Jones Indexes declined to comment on its timeline or re-weighting plans for the index.

S&P GSCI is set to follow in early November, but its review panel is expected to discuss on Thursday market conditions that usually set the ground for any change. S&P will issue later details on the discussions that will give "an indication of what should be happening to the index," said Mike McGlone, its senior director for commodities.

COMMODITY FASHION

After years of negligible interest, commodity indexes came into fashion about eight years ago as the commodities boom got in gear, giving pension funds and passive investors a chance to invest broadly in raw materials without the risk of taking delivery of a bushel of corn or barrel of oil.

Demand for simple passive holdings has slowed as investors realize that a more dynamic approach can yield better results in volatile markets, but the vast sums of money still attached to these products can make waves in many commodity markets that are far smaller than fixed-income or equity markets.

A growing number of investors are now asking their banks to modify the mainstream indexes to better suit their needs, perhaps to avoid commodities with punitive roll returns or minimize exposure to a particular asset.

"I think broadly around half of the global commodity index book is now customized in some way as compared to a pure benchmark," said Kamal Naqvi, Managing Director and Global Head of Institutional Commodity Sales at Credit Suisse, which is in the final stages of recalibrating its three -year-old benchmark index. It may add palladium and European wheat.

"This phenomenon had started before 2008, but it accelerated from that year and again from mid-2010 when there started to be bigger differentiation in returns between individual commodities," Naqvi added.

Four other major commodities indexes are expected to announce their 2012 line-up in November or December: the Reuters-Jefferies CRB ; the RICI founded by renowned commodities investor Jim Rogers; the DBLCI managed by Deutsche Bank; and the Merrill Lynch Commodity Index (MLCX).

They are smaller but still important. Merrill Lynch's suite commands about $20 billion, none of that to Brent as it is required to select only one of any given commodity. The RICI estimates its tracking funds at $6 billion to $9 billion and about $7 billion in funds tracks the CS index family, both of which are split near evenly between the two crudes. And the Reuters-Jefferies venture, which does not provide any tracking estimates, is also considering broadening its 19-market mix to include Brent.

"I think given what's going on in the global marketplace, it is prudent to continue to evaluate and consider Brent for inclusion in the benchmark," said Eliot Geller, managing director at Jefferies Asset Management.

Ends --

By Jonathan Leff and Barani Krishnan, Reuters

For Commodities Now with permission.