Commodity mutual funds offer an interesting, and potentially rewarding, way to diversify an investment portfolio beyond stocks and bonds. Since the prices of commodities tend to rise in step with inflation, they can be used as a hedge against inflation. This movement also runs counter to stock prices, which is a feature that also makes them attractive to investors.
Typically, commodities are defined as things that 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.
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 are sold before the contract expires. That means the average investor never takes physical delivery of the commodity, rather they are looking to make money on their investment through the changes in the commodity's value over time.
Traditionally, individuals playing in the futures market invest using a margin account, which allows them to hold a contract while providing only around 5% of the contract's value. While this approach creates windfall profits for some, the added risk produces as many losers too.
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 their risk too.
For example, the S&P GSCI Commodity Index, or SPGCCITR, is composed of twenty-four different commodities in a proportion that reflects the value of their production in the world's economy. This means that energy futures make up around 69.8% of the GSCI, and agricultural commodities make up around 15.3% of the index (as of July 2014).
Commodities are closely tied to the health of the local economy, and inflation specifically. That's because most commodities are quickly consumed, thereby causing prices to be directly tied to the cost of living. Due to this inherent characteristic, they're often on the upswing during inflationary times, and this creates a natural hedge for stock prices.
The market prices of most common stocks go 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 and the price of the company's stock drops too.
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 a 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 a way as to mimic the composition of the GSCI. PIMCO, on the other hand, caps its energy holdings at 33% (remember the GSCI's is at 69%), and has larger exposure to industrial metals such as gold.
The list below contains some of the best known commodity mutual funds and index funds available today:
One alternative to commodity mutual funds is to create a portfolio of mutual funds that invest in companies that are in the commodity business. For example, it's possible to 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 the investment's return. The following articles can help anyone that would like more information on the basics of mutual fund investing:
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