Commodity Mutual Funds: Meaning, Types, and Benefits

Thanks to technology, investing has become easier than ever. Stocks, mutual funds, and fixed-income securities have been popular choices among investors for some time now. However, another asset class that is taking precedence among investors is commodities. Commodities are physical products used as raw materials for producing goods, such as crude oil, rubber, or agricultural commodities. You can invest in commodities directly by trading on the commodity exchange or indirectly by investing in commodity mutual funds. The article covers in detail commodity mutual funds, their types, and their advantages.

What Are Commodity Mutual Funds?

Commodity mutual funds invest at least 95% of their assets in agricultural commodities such as coffee, livestock, food grains, and seeds and non-agricultural commodities such as oil, fuels, textiles, and chemicals. The mutual fund makes a profit when the value of these commodities goes up, and it makes a loss when the underlying commodities price goes down.

How Do Commodity Mutual Funds Work?

The structure of commodity mutual funds is similar to Exchange Traded Funds (ETF) or Funds of Funds (FoF). They invest in commodities through Exchange Traded Commodity Derivatives (ETCD), which are futures and options of commodities. Alternatively, they invest in companies dealing with commodities such as natural resources or agricultural commodities. This is because SEBI doesn’t allow mutual funds to invest in physical commodities directly apart from gold.

The performance of a commodity mutual fund depends on the performance of the underlying commodities in the fund. This directly affects the NAV (net asset value) of the fund. If the price of the commodity rises, the NAV of the fund also rises. If the fund manager books profits, it is equally divided among all the unit holders. In case the price of the commodity falls, the NAV of the fund also falls.

Features of commodity mutual funds:

• Wide choice: There are multiple categories and subcategories of commodity mutual funds that invest in several commodities. You can choose from a wide variety of funds to invest in for your short and long-term goals.
• Hedge against market volatility and inflation: Commodity mutual funds are not affected by market movements. Moreover, they are inversely related to stock market movements. Hence, they act as a perfect hedge against market volatility and protect your portfolio from downside risk. Moreover, as inflation rises, commodity prices increase; hence they are one asset class that is positively impacted by inflation.
• Diversification: Commodity mutual funds are a perfect tool for diversification. They help reduce the downside risk in a portfolio by hedging the market and inflation risk.
• Experienced fund manager: Commodity trading is different from equity trading and requires a lot of experience. Hence the fund managers managing commodity funds are very experienced and can give you significantly high returns.
• Returns: Commodity mutual funds give higher profits when the underlying price of commodities rises. This happens when the demand for a commodity is higher than its supply. Investing in such commodities will increase the overall return of the fund.  
• Risks: Commodity mutual funds are not affected by volatility in equity markets, but they are not risk-free. The prices of commodities are affected by rainfall, geopolitical factors such as war, and natural disasters such as earthquakes.

Types of Commodity Mutual Funds

There are different types of commodity mutual funds in India. These vary based on their investment objective and investment strategy:

• Natural resources fund: This type of commodity fund invests in companies that have exposure to natural resources such as oil, gold, silver, and renewable energy. Natural resources fund doesn’t directly invest in natural resources but in companies that deal in these resources. So, the profit of the fund depends on the prices of natural recourses and the performance of these companies on the stock market.
• Basic or true commodities fund: Basic or true commodities funds invest directly in physical commodities that occur naturally, such as metals, food grains, etc. They are very risky as they are prone to fluctuations in the market prices of the commodities. However, they are quite a popular kind of commodity funds in the market.
• Future funds: These funds are the riskiest type of commodities fund, as the manager takes a bet on futures and options. So, these funds do not directly trade in commodities but their futures contract. Since the futures market is very volatile, they are the riskiest types of funds.
• Combination funds: Combination funds invest in a combination of physical commodities and their futures. The physical commodities ensure the volatility is minimal, whereas the futures contract ensures the risk is considerable.
• Index funds: Index Funds are passively managed mutual funds that buy commodities based on the price on the benchmark index.

Benefits of Commodity Mutual Funds

• Protection against inflation: The price of the commodities is always in line with the inflation rate in the economy. Moreover, the returns from commodity mutual funds can negate the loss of currency devaluation or loss in the equity markets. Hence it acts as a perfect hedge against inflation.
• Hedge against market volatility: The price of certain commodities, such as gold and silver, does not move in tandem with the equity markets. In fact, the prices of these commodities rise when the markets are underperforming. Hence, they offer better returns even during bearish market conditions. Therefore, commodity mutual funds act as a perfect hedge against market volatility.  
• Diversification: Since commodity mutual funds do not correlate with equity or debt markets, they act as a unique asset class in a portfolio. This ensures there is enough diversification and protects the portfolio returns from falling during market downturns.
• Experienced fund manager: The fund managers who manage commodity mutual funds are highly experienced. They also conduct extensive market research before selecting commodities for the portfolio and strive to make higher returns.
• Wide choice: There are different types of commodity mutual funds in the market, and each of them operates in a different way. Hence as an investor, you have a wide variety of funds to choose from for your short and long-term financial goals.
• High returns: Commodity mutual funds have the potential to make high returns. This is because during certain geopolitical events, some commodities become scarce, and due to low supply and high demand, the price of these commodities can rise, which will increase the return of commodity mutual funds.

Who Should Invest in Commodity Mutual Funds?

The following kind of investors can consider investing in commodity mutual funds:

• Commodity investing is very risky. This is because the prices of commodities fluctuate continuously, and hence the returns of commodity funds are subject to extreme volatility. Therefore, investors with a very high-risk appetite can consider investing in commodities.
• Although commodity funds support short and long-term goals, investing in commodities for a long-term tenure can be very beneficial. This is because the price of commodities will stabilize and increase in the long term. Hence investors looking to accumulate long-term wealth can consider commodity mutual funds.
• Investors who want to diversify their mutual fund portfolio can consider investing in commodity funds. This is because they are affected by market volatility and act as a perfect hedge against inflation and market risk.
• Investing in commodities requires adequate market knowledge as they are affected by complex macroeconomic factors. If you have good knowledge about how the commodity markets work, then you can invest in them.

Risks of Investing in Commodity Mutual Funds

• Price volatility: Commodity prices can be very volatile. If a fund is tracking a single commodity, then in the short term, the fund will be a very risky bet. Moreover, commodity funds that invest in futures and options are also quite risky.
• Limited liquidity: Commodities are less traded when compared to equity shares. Hence it can get difficult to sell commodities at a desired price. This could be difficult for fund managers if they want to exit a commodity quickly, and this will ultimately affect the returns of the fund.
• Leverage: Commodity trading allows investors to trade using leverage. This means investors can trade with a borrowed amount. Although this could lead to higher profits, the risk of incurring higher losses is also high.

How to Invest in Commodity Mutual Funds in India?

You can invest in commodity mutual funds through any of the following ways:

• Directly: You can invest in a commodities fund directly by logging into the fund house’s website or visiting their nearest branch. You will have to fill out the application form, complete the one-time mandate in case of SIP (Systematic Investment Plan) and provide nominee details to start investing in a commodities fund. The expense ratio of investing through this method is very less compared to other methods. However, you will have to do your own research and monitor your portfolio regularly.
• Through a distributor: You can approach a distributor to invest in commodity mutual funds. A distributor will help you select a fund based on your goals, complete the application process, and even monitor your portfolio regularly. However, they charge a small fee for doing this. Hence the expense ratio is slightly higher in this case.
• Using a Demat Account: You can also invest in commodity mutual funds using a Demat account. However, brokerage charges are levied, which makes this method costlier than others.
• Online platforms: Several online platforms allow you to invest in commodity mutual funds. There are platforms that offer direct and regular mutual funds. You can choose a platform based on its user-friendliness and ease of access. These platforms also offer regular portfolio monitoring and allow suggested funds to rebalance your portfolio.

Things to consider before investing in commodity funds

• Investment objective: Before investing in commodity mutual funds, you must check the fund’s investment objective. Next, you must align it with your goals to find out if it’s the best fit for you. Only if the investment objective matches your goals, invest in the fund.
• Risk tolerance: Commodity funds aren’t risk-free. They are prone to volatility in commodity prices which are affected by geopolitical risks. Hence, you must invest in these funds only if you have a high appetite for risk.
• Performance of the fund: Before investing in commodity funds, you must check the past performance of the fund. Although the fund’s past performance doesn’t guarantee future returns, it will give an idea about the fund’s ability to generate returns in different market conditions. Comparing the fund’s performance with its peers and the benchmark will also help in understanding the return potential of the fund.
• Expense ratio: A fund’s expense ratio is an important parameter to check as expenses are deducted from the profits. Hence, a high expense ratio will reduce the profitability of the fund. So, you must choose funds with a low expense ratio.
• The expertise of the fund manager: A fund manager for a commodity mutual fund should be highly experienced and efficient. The returns of the fund are dependent on the fund manager’s expertise. You can check a fund manager’s expertise by looking at the past performance of the fund and also checking the performance of the other funds that he manages.

Frequently Asked Questions

1. What Is a Commodity Mutual Fund?

   A commodity mutual fund invests in commodities such as gold, silver, oil, petroleum, and agricultural products, either directly or indirectly. They are an excellent tool for diversification and act as a perfect hedge against inflation and market volatility. Investing in commodity mutual funds can also help accumulate wealth in the long term and hence suits long-term goals.

2. Should I Invest in Commodity Mutual Funds?

   Commodity mutual funds help in diversification, achieve long-term goals, and act as a hedge against inflation. If you are an investor whose risk tolerance level and want to protect your portfolio against downside risk, then you can consider investing in it.

3. Is It Safe to Invest in Commodities?

   It helps in protecting a portfolio from downside risk, but they aren’t immune to risk. Their returns depend on commodity prices which are exposed to geopolitical risks and natural calamities. Moreover, they are less liquid than equities and debt securities. Hence it is not entirely safe to invest in it. However, they are not affected by market volatility.

4. Which Is Better Stock or Commodity?

   Stock and commodity are two different asset classes and serve different purposes. The former helps accumulate long-term wealth and has the potential to give high returns, and the latter helps in protecting a portfolio from downside risk. Hence it is difficult to choose between the two. However, you can invest in both and diversify your portfolio.

5. How to Invest in Commodities in India?

   You can invest in commodities through commodity mutual funds. Or you can directly trade in commodities on the commodity exchange through your demat account. However, investing in commodities requires knowledge; hence as a retail investor, it’s better if you pick it for your portfolio.