What Are Commodity Funds & How Do They Work?

Stocks, bonds, and cash are all fairly standard components of a diversified investment portfolio. Commodity funds sometimes are included in this mix. These investments often have different cycles from those of equities and fixed-income products, and for that reason they can sometimes offset adverse moves in other investments. They do, however, come with risks that may be different from other investments.

What are commodity funds?

Put simply, a commodity fund is an investment that focuses on the trade of physical commodities. Commodities can include a variety of raw materials including, but not limited to:

• Natural resources such as oil and natural gas
• Agricultural goods like cotton, wheat, corn, sugar, and soy
• Livestock and poultry including cows, hogs, and chickens
• Precious metals like gold and silver

Commodity funds may be tied to a commodity-focused index, invest in companies that operate in commodity-based industries, or have direct commodity holdings. As the value of these commodities (and any related companies) rises, the commodity fund’s value also grows.

This is very different from investing in the commodities themselves. Although an investor could theoretically buy gold bullion or grow acres of corn, this isn’t practical. The typical investor has a much easier time buying funds that expose them to commodities in a much more indirect way.

Types of commodity funds

When adding commodity investments to a portfolio, an investor is able to choose from a few different investment types. These include true commodity funds, commodity index funds, and futures-based commodity investments.

• Commodity funds.

  A true commodity fund might buy shares of a fund that holds a direct position in oil or purchases physical silver bullion. For many investors, this is the next closest thing to personally owning and managing commodity assets, without needing to herd cattle or plow fields of wheat.‍

• Commodity index funds.

  Commodity index funds offer investors exposure to the commodities through a linked index, which tracks various commodity assets. These can be thought of as commodity mutual funds: Often, they involve investing in a number of different companies that manage commodities, and may help spread an investor’s risk.

• ‍Futures-based commodity funds. These investments work by purchasing futures contracts on specific commodities. They allow an investor to speculate on the future price of a particular commodity, often using leveraged funds, while also contractually obligating them to purchase the commodity if it reaches the price specified in the futures contract. This leveraged contract model can amplify both gains and losses, so futures-based commodity funds are generally utilized by more sophisticated investors.
  

Benefits & risks of commodity funds for investors

As with all investments, commodity funds bring with them a degree of risk. However, they also provide specific benefits that make them a favorite with some investors. Here are a few benefits of commodity funds:

• They offer portfolio diversification.

  While commodity index funds are similar to exchange-traded funds (ETFs) and mutual funds, futures-based contracts and true commodities are a very different type of investment. For this reason, they can help investors who are interested in further diversifying their holdings.

• Commodities don’t always move in tandem with traditional indices.

  Generally, commodity markets ebb and flow in relation to their own unique factors, rather than moving in step with traditional equity markets. This may help investors hedge against losses during market downturns.

• Commodity pricing has a traditionally higher upside.

  Because commodities operate on a supply-and-demand model, they have a high potential for value increase. As they become more in demand (especially in terms of nonrenewable commodities), prices tend to rise.

• They hedge against inflation.

  The value of many commodities tends to rise in tandem with consumer price inflation. This helps investors better hedge against inflation-related losses.
  

Of course, these investments also come with certain risks to note. They include:

• Commodity markets tend to be volatile.

  Because there are so many factors that affect commodities themselves as well as their value, the markets can see wild price swings in a short period of time. ‍

• They are subject to economic and political events.

  Any number of economic trends, political events, international policies, and even extreme weather (such as a drought’s impact on wheat production) can affect commodities trends and pricing. While every investment can be influenced by outside factors, commodities can be very sensitive in the short-term.

The bottom line

Investors sometimes consider adding commodity funds to their investment portfolio, in one form or another. These allow the everyday person to invest in important commodities such as agriculture, energy production, natural resources, and even precious metals.

Commodity investments also come with some unique risks. The volatility of these investments is a notable factor, for instance, as is the influence that external factors can have on their value.

With that said, commodities offer many options. They can be purchased in the form of futures contracts, index funds, or even the physical commodities themselves, and many investors purchase these to help hedge against inflation and further diversify their portfolio—without needing to plow their own wheat or stash away gold bars.