Commodity Funds 101

Commodities get a lot of attention from the media. The price of oil, gold, corn, soy and hogs are in the national news nearly every day. While investing in the commodities markets is a fairly sophisticated endeavor, commodity mutual funds provide an opportunity for almost any investor to get a piece of the action.

A Variety of Fund Types

The generic label "commodity fund" actually captures several distinct types of investments. These include:

• Commodity Funds These funds are true commodity funds in that they have direct holdings in commodities. For example, a gold fund that holds gold bullion would be a true commodity fund.
• Commodity Funds That Hold Futures Holding commodity-linked derivative instruments is a much more common mutual fund strategy for investing in the commodities markets. Most investors have no desire to take delivery of hogs, corn, oil, or any other commodity. They want to profit from price changes. Purchasing futures contracts is one way to achieve this objective.
• Natural Resource Funds Funds that invest in companies that are engaged in businesses that operate in commodity-related fields, such as energy, mining, oil drilling, and agricultural businesses, are often referred to as natural resource funds. While they often hold neither actual commodities nor commodity futures, they provide exposure to the commodities markets by proxy.
• Combination Funds Some funds invest in a combination of actual commodities and commodity futures. Gold funds, for example, may have underlying holdings that include both bullion and futures contracts.

A Variety of Investment Strategies

In addition to a variety of formats, commodity funds also offer a variety of investment strategies, including active management and passive management. Active portfolios buy and sell in an effort to outperform a benchmark index. Passive portfolios seek to replicate a benchmark index and match its performance. Passive strategies can be implemented using index funds or exchange-traded funds (ETFs).

Pros and Cons of Investing in Commodity Funds

Commodities offer portfolio diversification. Investing in futures contracts or actual commodities provides a portfolio component that is not a traditional stock, bond, or a mutual fund that invests in stocks and/or bonds. Historically, commodities have had a low correlation to traditional equity markets, meaning that they do not always fluctuate in tandem with market movements. For many investors, achieving this low correlation is the primary objective when seeking to add diversification to a portfolio.

Commodities also offer upside potential. The raw materials used in construction, agriculture and many other industries are subject to the laws of supply and demand. When demand rises, prices generally follow, resulting in a profit for investors.

Finally, commodities offer a hedge against inflation.

On the Other Hand

The commodities markets can be volatile and subject to wild, short-term price swings and long lulls. Over the course of just a few days, prices can go from record highs to record lows. For a closer look at the range of price movements, research the price of gold over the past 30 years and the price of copper in 2008.

Another item of note is the composition of various mutual funds and the benchmark indexes that they track. In many commodities indexes, energy is often the heavyweight, taking up more than half of the index. When a mutual fund seeks to directly replicate the index, more than half of the fund's assets will be in energy. Some funds place limits on the percent of the portfolio invested in a single commodity to avoid an over-concentration in a single investment.

Look Before You Leap

While commodities provide access to some interesting investments and strategies, the commodities markets are complex, and not as familiar to most investors as the stock market or bond market. Before you invest in commodities funds, read the fund's prospectus and annual report, and be sure that you understand what you are buying and the role it plays in your portfolio. Likewise, pay attention to the fund's holdings. Make sure that you are aware of how much of the fund's assets are weighted to a particular market sector and plan accordingly for other parts of your portfolio. Keep in mind the volatile nature of the commodities markets and limit holdings to a small percentage of your total portfolio.