Investment

What are commodity funds and how do they work?

Commodity funds have emerged as an alternative investment vehicle that offers exposure to physical commodities and raw materials. For investors looking to diversify beyond traditional stocks and bonds, commodity funds can provide a way to gain access to this asset class. Read on to learn more about this investment option.

What is a commodity fund?

A commodity fund is an investment that focuses on trading various commodities. This includes natural resources like oil, gasoline, and natural gas, precious metals such as gold and silver, agricultural products like wheat, corn, and coffee beans, and even livestock. The fund’s value is directly correlated to the underlying prices of the commodities in which it invests.

These funds allow investors to gain exposure to commodities without having to directly invest in the physical commodities themselves. Some key commodities that commodity funds invest in include:

  • Energy commodities like crude oil, gasoline, natural gas and heating oil
  • Precious metals like gold, silver, platinum and palladium
  • Agriculture commodities like corn, wheat, soybeans and coffee
  • Livestock like lean hogs, live cattle and feeder cattle

How do commodity funds work?

There are a few main ways that commodity funds gain exposure to commodities. These include:

Physical commodities

A few commodity funds invest directly in physical commodities, although this is less common. The fund purchases and stores the actual commodity, like precious metals or agricultural goods. This allows the fund to closely track the spot price. However, physical storage and delivery costs can be high.

Equity shares

Some commodity funds invest in the equity shares of companies involved in commodity-related industries like mining, oil production, biofuels, agriculture, etc. As the share prices of these companies rise or fall, the fund’s value is affected. Investing in equities gives funds more liquidity than futures contracts.

Futures contracts

A riskier method is by investing in futures contracts for the underlying commodities. The fund does not have to take physical possession of the commodity. Instead, the futures contracts allow the fund to speculate on the future price movements of the commodity.

As the price of the commodity fluctuates, the value of the futures contract changes, thereby impacting the overall value of the fund.

Types of commodity fund investment vehicles

Commodity mutual funds

Commodity mutual funds are structured as traditional open-ended mutual funds. Invest in mutual funds if you want an easy and risk-adjusted way of investing in commodities.

Commodity ETFs
Commodity Exchange-Traded Funds (ETFs) trade on stock exchanges just like stocks. They offer intraday liquidity and transparency.

Commodity index funds

These funds track an underlying commodity index, like the Bloomberg Commodity Index. The index includes a basket of various commodities.

Commodity pools

These are privately managed investment funds only available to accredited high-net-worth investors. They offer wider commodity exposure.

Conclusion

While commodity funds can provide portfolio diversification and a potential hedge against inflation, they do come with some drawbacks. Commodity markets can be complex and volatile. Funds focused on futures may have different tax treatments than regular investments. There are also regulatory risks that can impact commodity prices.

For investors who understand the nuances, commodity funds can be a useful addition to an investment portfolio. They allow retail investors to allocate a portion of their assets to commodities just like they would with stocks and bonds. With the variety of fund structures now available from commodity mutual funds to ETFs, commodity investing has become more accessible.