Commodities trading involves buying and selling hard assets that are typically agricultural in nature or naturally occurring. Investing in commodities often means trading futures contracts, which can be profitable but risky. Commodity mutual funds are an alternative way to diversify using commodities, and they can yield several benefits to investors. If you’re interested in branching out with your portfolio, this guide walks you through the most important things to know about commodity funds. A financial advisor can help you explore the full range of ways to diversify your portfolio.
What Is a Commodity Mutual Fund?
Let’s review what a mutual fund is first. In a nutshell, it represents a basket of investments. That basket can include stocks, bonds, real estate or other investments representing different sectors and asset classes for all-in-one-diversification. Investors pool their money into the fund, sharing in the gains and losses as the fund’s price fluctuates over time. Unlike stocks, mutual funds don’t trade on an exchange; their price is settled once each day at the close of trading.
A commodity mutual fund is a fund that focuses exclusively on commodities, such as:
- Oil and natural gas
- Wheat and corn
- Coffee and oranges
- Gold and silver
Many commodities are essentially raw materials that are used to produce other goods. Oranges, for example, are key for orange juice production while corn is used to produce food items as well as ethanol. The definition of commodities has evolved over time to include things like foreign currencies and cellular phones.
Types of Commodity Funds
Commodity mutual funds aren’t all like in terms of what they invest in and their overall objectives. There are five types of commodity funds you can invest in:
1. Index funds
An index fund is designed to track an index or benchmark, such as the S&P 500 or the Nasdaq Composite. The goal of these funds is to match the performance of the underlying index. A commodity index fund tracks a specific commodities index, such as the Dow Jones Commodity Index, which tracks more than a dozen commodities traded on exchanges.
2. Commodity futures funds
Futures are a speculative investment. When you trade futures, you’re essentially making an educated best guess about which direction an investment’s price will move within a set time frame. Commodity futures funds invest in futures contracts for various commodities, such as livestock or natural gas. If the price trends the way you anticipate that it will, then commodity futures can be lucrative. But, there is more risk involved compared to other commodity funds.
3. Commodity funds
A commodity fund can be considered a “pure play” investment if it invests directly in commodities. For example, you might invest in a fund that only holds silver, gold or other precious metals. Some commodity funds may offer indirect exposure to commodities by investing in the companies that produce them, rather than the commodities themselves.
4. Natural resource funds
Natural resource funds invest in companies that offer exposure to commodities. For example, a fund might invest in companies in the mining, drilling, timber or farming industries. What sets these commodity funds apart is that they’re exclusively natural resource-related; a commodity mutual fund that invests in foreign currencies wouldn’t fit into this category.
5. Combination funds
Combination funds can offer exposure to both commodities and commodities futures. For instance, you might come across a fund that invests in orange groves and orange juice futures. Since these funds include futures, they tend to carry more risk versus an index, commodity or natural resource fund.
It’s also worth noting that commodity funds can be actively or passively managed. When a fund is actively managed, the fund manager plays a direct role in deciding which assets to buy or sell within the fund. The objective of the fund may be to beat a particular benchmark or index. A passive fund, on the other hand, only attempts to match a benchmark. As a result, the investments in the fund turn over less frequently.
Advantages of Commodity Fund Investing
Commodities aren’t your typical stock or bond investment and you might be wondering what’s in it for you if you decide to invest. While commodities may not be right for every investor, there are several benefits to consider:
- Increased diversification. Similar to real estate, commodities typically have a low correlation to the stock market. That makes them a suitable investment for hedging against volatility. Commodity funds can help insulate your portfolio’s value against the market’s ups and downs.
- Inflationary protection. Rising inflation can cause stock prices to fall but commodities can offer shelter to investors. If commodity prices rise due to inflation, commodity fund prices can also increase, yielding gains in the process.
- Accessibility. Buying a commodity fund can be easier than investing in commodities or commodities futures directly, thanks to online brokerages. If you’re interested in adding this asset class to your portfolio, it can be as simple as choosing a fund and investing through your broker.
Commodities can also offer strong performance, particularly when stocks falter due to volatility, inflation or other economic pressures. For example, between 1970 and 2017, commodities had an average annual gross return of 21.98% in years that had above-median inflation. On the other hand, commodities recorded an annual gross loss of 1.97% in years when inflation was below median levels.
Which specific commodity leads the entire sector in performance varies. In 2021 and 2022 lithium, a key ingredient in electric vehicle batteries, led the pack with returns of 442.8% and 72.49%, respectively. From 2017 through 2020, precious metals palladium and silver posted the highest returns.
Commodity Mutual Funds Can Be Risky
Any investment entails risk and commodity funds are no different. What distinguishes commodity funds from other mutual funds is the nature of the underlying investments. Commodities, in general, can be subject to wide price swings, which can directly affect your returns. When you’re investing in commodity futures funds, the risk is even greater since there’s no guarantee that prices will move in the direction you need or want them to.
The key is keeping risk and reward in perspective when investing in commodity funds. A passively managed commodity index fund, for instance, may be less risky than an actively managed futures fund. The trade-off is that the futures fund may deliver higher returns. Being aware of how the two balance one another out can help you determine which commodity funds are right for your portfolio.
Commodity funds may be unexplored territory in your portfolio but there are several good reasons to consider them. They can offer a hedge against both volatility and inflation, while potentially matching or exceeding the performance of traditional stock and bond mutual funds. Because they involve more risk, however, they may not be the best choice if you’re newer to investing or you prefer to be more conservative with your investments.
Tips for Investing
- Consider talking to a financial advisor about what needs commodities and commodity funds could fill in your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Think about whether you’d prefer to invest in a commodity mutual fund or exchange-traded fund. Exchange-traded funds or ETFs are mutual funds that trade on an exchange like a stock. Many are passively traded, meaning they have lower turnover and are more tax-efficient, but some adopt an active management strategy. Comparing the costs, underlying investments and investment strategy can help you decide whether you should invest in commodity mutual funds, commodity ETFs or a mix of both. Specifically, pay attention to the expense ratio, which reflects the annual cost of owning the fund. The lower this number is, the better.
Photo credit: ©iStock.com/Nordroden, ©iStock.com/shironosov, ©iStock.com/fotokostic