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 Commodity mutual funds are an interesting, and potentially rewarding, way to diversify your investment portfolio beyond stocks and bonds. That's because commodities are often viewed as a hedge against inflation. Meaning the prices of commodities tend to rise in step with inflation. This movement trends to run counter to stock prices - which is an attribute that makes commodity mutual funds so attractive to many investors.
Commodity Goods
In generally, commodities are defined as things that tend to come from the earth or are grown. This includes grains, minerals and metals, livestock, cotton, oils, sugar, coffee, and cocoa. Some of the more common commodities traded on the exchange include crude oil, hog bellies, cattle and wheat.
Commodities are traded in the spot market or in the form of futures contracts. Spot market trades are made for immediate delivery. For example, energy could be traded on the spot market and delivered immediately into the electrical network. When trading on the spot market, physical delivery of the commodity often takes place.
Commodity Futures
Commodities traded as futures are contracted for a "future" delivery date. Most investors in the commodity market trade in futures contracts and many of these contracts are sold before the contract expires. That means the average investor never takes physical delivery of the commodity itself, rather they are looking to make money on their investment through the changes in the commodity's value over time.
Traditionally, many investors playing in the commodities futures market invest using a margin account. When using a margin account the investor might only need to invest 5% of the contract's total worth to hold it. While this approach creates windfall profits for some, the added risk produces many losers too.
Commodity Index Funds
Whenever there is a need in the market, smart people are quick to fill that void. In the same way that traditional mutual funds allow investors to create portfolios of common stocks or bonds, commodity mutual funds give investors the option of adding commodities to their portfolio and limit the risk associated with the commodities market.
For example, the Goldman Sachs Commodity Index, or GSCI, is a composed of twenty-two different commodities in a proportion that reflects the value of their production in the world economy. This means that energy futures make up around 55% of the GSCI and agricultural commodities make up around 25% of the index.
Commodities and Inflation
Commodities are closely tied to health of the local economy and inflation specifically. That's because most commodities are quickly consumed and therefore prices are directly tied to the cost of living. Due to this inherent characteristic, commodities are often on the upswing during inflationary times and this creates a natural hedge for stock prices.
The market price of most stocks goes down when inflation is rising. There are several explanations for this, but the simplest has to do with the cost of borrowing. Inflation is usually associated with higher interest rates - and this makes borrowing more costly for a company. In turn, the increase in interest expense lowers earnings per share.
Mutual Funds and Commodities
To leverage this inverse relationship between stock prices and commodities, the investor has two options. The first is to buy into commodity mutual funds as the hedge against inflation. The two best known funds include the Oppenheimer Real Asset Fund (QRACX) and the PIMCO Commodity Real Return Strategy (PCRAX) fund.
The Oppenheimer fund attempts to hold commodity contracts in such as way as to mimic the composition of the GSCI. PIMCO, on the other hand, caps its energy holdings at 33% (remember the GSCI's ratio is 55%) and has larger exposure to industrial metals such as gold.
Best Commodity Mutual Fund / Index Funds
If you're interested in finding a list of some of the best commodity mutual funds / index funds available, here is our list of the well-known leaders in this area:
- Oppenheimer Real Asset Fund
- PIMCO Commodity Real Return Strategy
- Goldman Sachs Commodities Index
- Deutsche Bank Liquid Commodities Index
- Rogers International Commodities Index
- Dow Jones AIG Commodities Index
Alternatives to Commodity Funds
The alternative to commodity mutual funds is to create your own portfolio of mutual funds that invest in companies that are in the commodity business. For example, you can invest in gold mutual funds, natural resource mutual funds, oil companies, and other energy funds. Fidelity's Select Industrial Materials is a mutual fund of companies in the chemicals, metals, and building materials industry.
Remember that all the standard investment warnings apply to this situation. Make sure the fund's fee structure does not eat too much into your investment's return. If you want more information on the basics of mutual fund investing, the following publications can help:
About the Author - Commodity Mutual Funds
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