Banks are struggling to devise new commodity index products as once-fat returns fizzle out in a business worth $140 billion, putting pressure on bank commodity businesses already hit by tighter regulations.

Up until this year, the banks had managed to come up with fresh ways of perking up returns for the index products and retain uneasy investors

Up until this year, the banks had managed to come up with fresh ways of perking up returns for the index products and retain uneasy investors, who still see commodities as a bet against inflation.

As a flood of money into the sector has diluted returns, however, now even many of the complex products spiced up with computer algorithms are underperforming, and some investors are questioning their commitments to the sector. An erosion of the index investment business would remove an important remaining money-spinner for banks in commodities.

Their total turnover in the sector has tumbled by half to $7 billion, partly due to a regulatory crackdown on proprietary trading in which banks take positions on their own behalf rather than for clients. Industry figures acknowledge the difficulty in finding ways to recapture the high profits enjoyed during the early years of a commodities boom fuelled by Chinese hunger for raw materials.

“The asset class is getting more crowded. It’s harder and harder to get the risk premium that originally attracted investors into this space,” Dan Raab, head of commodity investor marketing and structuring at UBS Securities, told a recent commodities conference before unveiling new products.

UBS owns one of the two main indexes that attract the bulk of investment into the commodity index sector – the Dow Jones UBS index. The other is the S&P Goldman Sachs Commodity Index (GSCI).

Investors who piled into bank index products from about 2000, seeking to diversify portfolios and capture growth in emerging markets, were initially rewarded with juicy returns.

Standard indexes shot up during the early years of the boom, fuelled by China’s demand for commodities. The DJ-UBS total return index more than doubled from 2000 to 2007.

But the gains began to diminish due to the combined impact of the global financial crisis and a deluge of investment cash into a relatively thin commodity sector, forcing banks to come up with ever more complex products.

Since the start of 2008, the DJ-UBS index has lost a fifth. It is virtually flat this year compared with a 15 per cent rise in the S&P 500 equity index.

More worrying for the banks, many of the enhanced commodity products are also underperforming.