In this story, we will explore commodity funds to understand how they work, what they invest in, the benefits and risks, and who should invest in commodity funds. Towards the end of the blog, we’ll tell you about alternatives to commodity funds available on the Cube Wealth app.
A commodity like cotton or crude oil has the potential to generate returns. However, most retail investors wouldn’t want to physically own large quantities of cotton or crude oil.
This is where commodity funds step-in. Theoretically, a commodity fund follows the same basic tenet of any mutual fund: You own units of the fund but not the actual commodity or product itself.
Let’s look at commodity funds in detail to break down how a typical commodity fund works, the various types of commodity funds, and alternatives to commodity funds. But first, it would help to understand what commodities are.
Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth.
What Are Commodities?
Commodities are raw materials, goods, and services that can be bought and sold in exchange for cash or other commodities. A commodity may be hard or soft in nature.
Examples of commodities include:
Oil
Silver
Pulses
Cotton
Sugar
Commodities can be bought and sold on a commodity market or exchange. Most commodities are traded using futures contracts. Read about the commodity m
A commodity like cotton or crude oil has the potential to generate returns. However, most retail investors wouldn’t want to physically own large quantities of cotton or crude oil.
This is where commodity funds step-in. Theoretically, a commodity fund follows the same basic tenet of any mutual fund: You own units of the fund but not the actual commodity or product itself.
Let’s look at commodity funds in detail to break down how a typical commodity fund works, the various types of commodity funds, and alternatives to commodity funds. But first, it would help to understand what commodities are.
Important: This blog is meant to educate readers and the information furnished here is not to be construed as investment advice from Cube Wealth.
What Are Commodities?
Commodities are raw materials, goods, and services that can be bought and sold in exchange for cash or other commodities. A commodity may be hard or soft in nature.
Examples of commodities include:
Oil
Silver
Pulses
Cotton
Sugar
Commodities can be bought and sold on a commodity market or exchange. Most commodities are traded using futures contracts. Read about the commodity market in detail here.
Now that you know what commodities are, we can talk about commodity funds.
What Are Commodity Funds?
A commodity fund invests in one or more commodities similar to an equity fund that would invest in the stock of a company or various companies.
The performance of the commodity fund is directly linked to the value of the commodity it invests in. A rise or fall in the value of a commodity will impact the returns generated by the commodity fund.
Commodities are very volatile in nature and are affected by broad factors like supply & demand, economic conditions, geopolitics, trade relations, etc. A simple example would be the price of onions:
In December 2020, onions cost between ₹120 to ₹150 per kg. In January 2021, onions cost less than ₹50 per kg*.
Thus, commodity funds carry a degree of volatility and risk that investors need to be aware of. This uncertainty also puts the onus on the fund manager to go above and beyond to generate returns.
Types of Commodity Funds
1. True commodity fund or basic commodity fund
These funds invest in true physical assets like metals, land, natural resources, etc. A true or basic commodity fund can invest in Gold, Silver, Lead, and others.
2. Natural Resources commodity fund
A natural resource fund will invest in companies that are associated with natural resources like agriculture, energy, oil, mining, etc. These natural resources can range from precious metals to petrol.
3. Futures funds
Futures funds and even most public investors don’t want to actually get the commodity delivered to their doorstep. Instead, they want to generate profits by leveraging a commodity’s price fluctuation.
In such cases, a futures contract becomes one of the best ways to invest in commodities. A futures contract is an agreement between a buyer and a seller that contains:
A pre-agreed price
A pre-agreed date of buying/selling/trading
The futures fund will hold various futures contracts and the returns will be tied to the profits generated in turn. However, this leads to a few interesting observations:
The fund manager will take an educated guess on the commodity’s future price
This educated guess may or may not be right due to high volatility that commodities carry
As a result, a futures fund is highly volatile and is widely accepted to be the riskiest fund of the lot. There are safer alternatives like debt funds, liquid funds, ultra short term funds, and arbitrage funds.
If you’re looking for similar returns but comparatively lower volatility, you can look to invest in conservative equity funds recommended by Cube Wealth’s mutual fund advisor, Wealth First.
Watch this video to learn more about Wealth First, Cube’s advisor
4. Combination funds
Combination mutual funds may invest in both the actual commodity and futures contracts. Hence the name, combination funds. For example, a combination fund may invest in crude oil and crude oil futures.
5. Index funds
Index funds mirror the value of the underlying index they invest in. For example, an index fund investing in the MCX iCOMDEX Bullion will track and mirror the value of the index.
Benefits of Commodity Funds
1. Diversification
Commodity markets are not linked to the equity market. Publicly available data on the internet suggests that the commodity markets and equity markets have a low or inverse correlation.
This may provide an investor with an opportunity to diversify as a means to hedge against the losses that may be incurred in the equity market.
Diversification within the commodity funds spectrum is also vast. Investors can choose from a range of commodity funds like true commodity funds, futures funds, index funds, etc.
These funds may invest in one or more commodities that all carry their own pros and cons. However, investors may find the unpredictability of commodity markets to be concerning.
Consult a wealth coach to know if you should invest in commodity funds or equity mutual funds.
2. Hedge against inflation
Certain commodities like gold and silver are known to gain more value during inflation. Apart from that, most commodity funds generate returns in line with global markets.
Most commodity funds are under the tutelage of an experienced fund manager. A fund manager’s call regarding the commodity or a futures contract can make or break the commodity fund.
This overreliance on the fund manager can be a risky factor in a commodity market that is known to be volatile. However, the right call may lead to better returns.
Risks of Commodity Funds
1. High volatility
Every market is subject to certain risks and volatility. However, the commodity market can experience erratic short term price fluctuations and volatility.
This can directly affect the overall performance of the commodity fund regardless of good or bad calls from the fund manager. You don’t have to look further than the price of silver from 2006-2021 to identify this:
Source: Google
2. Multiple risk factors
Commodities may be affected by a host of different factors like:
Demand and supply
Economic condition
International trade relations
Country specific issues
Geopolitical issues
Overall, commodity funds carry various uncertainties along with above-average volatility. An investor must do thorough research and consult a wealth coach before investing in any commodity fund.
Who should invest in Commodity Funds?
Commodity funds can be volatile over the short term and require a nuanced understanding of various macro and micro-economic trends. Thus, commodity funds may be an option for seasoned investors with an above-average risk appetite.
There are alternative investment options to commodity funds that you can invest in with proven advice from our expert wealth advisors:
Note: All facts & figures are as of 15-01-2021. Figures mentioned in the table above comprise publicly available data on Google. While we update our blogs regularly, check the Cube Wealth app for the latest facts & figures.
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