Commodity Mutual Funds
Presently there is no commodity mutual fund in India, but now the commodity futures market has come under the new regulator SEBI, hence there is great chance of commodity mutual funds being allowed in India. This column is therefore based on US experience where commodity mutual funds have been successful.
Commodity Mutual Funds are funds which basically invest in commodities, such as gold, oil, metals, agri commodities etc. They also invest in commodity futures and options. Some commodity funds invest in the stocks of companies, like gold funds which invest in the stocks of gold mining companies. Commodity prices are influenced by the performance of economy or the forces of demand and supply. Instability in commodity prices can give investors leverage which helps them generate revenue. Commodity mutual funds are a relatively new development. They allow investors, especially retail investors, to obtain the diversification benefits of commodity investments, benefits that were historically much harder to achieve.
These funds are true commodity funds in that they have direct holdings in commodities. For example, a gold fund that holds gold, bullion would be a true commodity fund.
Commodity Funds That Hold Futures Holding of commodity-linked derivative instruments like futures and options are much more common mutual fund strategy for investing in the commodities markets. Most investors have no desire to take delivery of Rubber, Cotton, Castor seed, RM Seed, Metals, Oil or any other commodity, they simply want to profit from price changes. Purchasing Futures or option contracts is one way to achieve this objective.
Pros and Cons of Investing in Commodity Funds
- Commodities offer portfolio diversification. Investing in futures contracts or actual commodities provides a portfolio component that is not a traditional stock, bond, or a mutual fund that invests in stocks and/or bonds. Historically, commodities have had a low correlation to traditional equity markets, meaning that they do not always fluctuate in tandem with market movements. For many investors, achieving this low correlation is the primary objective when seeking to add diversification to a portfolio.
- Commodities also offer upside potential. The raw materials used in construction, agriculture and many other industries are subject to the laws of supply and demand. When demand rises, prices generally follow, resulting in a profit for investors.
- Investing in commodity mutual funds provides important benefits for investors. Commodity mutual funds typically invest in a broad basket of commodities. Investing in a broad index of commodities can help investors offset the risk of investing in stocks or bonds. Commodity mutual funds also allow retail investors to offset or hedge against increases in their costs of living, especially increases in food and energy prices
Finally, commodities offer a hedge against inflation explains how these diverse asset classes provide both downside protection and upside potential.
Flows to commodity mutual funds have little or no influence on commodity prices.
Three key factors illustrate why flows into commodity mutual funds cannot explain commodity price movements since 2004. First, commodity mutual funds experienced net outflows on average from January 2006 to June 2008 while commodity prices rose. Second, flows into commodity mutual funds are spread across a wide range of markets and thus do not concentrate investment in a particular commodity. Finally, the $47.7 billion in commodity mutual funds as of December 2011 is miniscule relative to the size of global commodity markets.
The commodities markets can be volatile and subject to wild, short-term price swings and long lulls. Over the course of just a few days, prices can go from record highs to record lows. Another item of note is the composition of various mutual funds and the benchmark indexes that they track. In many commodities indexes, energy is often the heavyweight, taking up more than half of the Index. When a mutual fund seeks to directly replicate the index, more than half of the fund’s assets will be in energy. Some funds place limits on the percent of the portfolio invested in a single commodity to avoid an over-concentration in a single investment.
While commodities provide access to some interesting investments and strategies, the commodities markets are complex, and not as familiar to most investors as the stock market or bond market. Before one invests in commodities funds, the fund’s prospectus should clarify and outline the associated risk so that participants take informed decision and they are made sure that they understand what they are buying and the role it plays in their portfolio.
Likewise, they can pay attention to the fund’s holdings. They can make sure that they are aware of how much of the fund’s assets are weighted to a particular market sector and plan accordingly for other parts of their portfolio.
Number and Assets of US Commodity Funds
Let us examine the growth of commodity mutual funds, and put this growth in its appropriate context, and assess the impact of this growth on commodity markets and prices. The assets and number of such funds have grown substantially as seen in the chart below, which is in parallel with the rise in commodity prices. The relationship between the assets of commodity mutual funds and commodity prices has led some to argue that commodity mutual funds are responsible for rising and volatile commodity prices
But there is little if any evidence indicating that commodity mutual funds have caused rises in commodity prices over the past decade. The apparent relationship between commodity prices and assets in commodity mutual funds is mostly mechanical Its value is rising simply because the value of a fund’s holdings must rise when the prices of commodities rise, even without any new investment on the part of mutual fund shareholders.