Trading commodities can be done in different ways. You can buy the physical commodity, hold it, and later sell it. This is the basic, old fashioned way. These days, you can trade through varied sources; futures contracts, which are basically contracts to buy or sell a specific amount of a commodity at a certain price on a designated date. This is the riskiest, most advanced way of trading commodities. The other way, which is simpler, less risky, is through commodity Funds or ETFs (exchange-traded fund).
Commodity Funds or ETFs are popular because they are a simple way to trade on the price and performance of any commodity without actually owning the commodity itself, and without having to learn how to purchase futures or other types of derivative products. They consist of either company stocks that are involved with the commodity, or they consist of futures and derivative contracts in order to track the price of the underlying commodity, or in some cases indexes.
# ETFs or Mutual Fund?
The main difference between ETFs and mutual funds is that ETFs are mutual funds that trade on an exchange like stocks. Mutual Funds, on the other hand, don’t trade on an exchange; their price is settled once each day at the close of the trading. Most of ETFs and mutual funds are passively traded, meaning they have lower turnover and are more tax-efficient, but some adopt an active management strategy. When a fund is actively managed, the fund manager plays a direct role in deciding which assets to buy or sell within the fund. The objective of the fund may be to beat a particular benchmark or index. A passive fund, on the other hand, only attempts to match a benchmark.
Comparing the costs, underlying investments and investment strategy can help you decide whether you should invest in commodity mutual funds, commodity ETFs or a mix of both. Specifically, pay attention to the expense ratio, which reflects the annual cost of owning the fund. The lower this number is, the better.
# Types of Commodities you can Invest in
If you can name a commodity, you can probably invest in it. Some of the most common commodity investments include:
- Precious Metals
- Oil and Natural Gas
- Agricultural Products (wheat, corn, coffee, oranges, etc.)
# Types of Commodity Funds
There are five types of commodity funds you can invest in. Each invests in different types of products and has a different overall objective.
An index fund is designed to track an index or benchmark, such as the S&P 500 or the Nasdaq Composite. The goal of these funds is to match the performance of the underlying index. A commodity index fund tracks a specific commodities index, such as the Dow Jones Commodity Index, which tracks more than a dozen commodities traded on exchanges.
A commodity fund can be considered a “pure play” investment if it invests directly in commodities. For example, you might invest in a fund that only holds silver, gold or other precious metals. Some commodity funds may offer indirect exposure to commodities by investing in the companies that produce them, rather than the commodities themselves.
Futures are a speculative investment. When you trade futures, you’re essentially making an educated best guess about which direction an investment’s price will move within a set time frame. Commodity futures funds invest in futures contracts for various commodities, such as livestock or natural gas. If the price trends the way you anticipate that it will, then commodity futures can be lucrative. But, there is more risk involved compared to other commodity funds.
Natural Resource Funds
Natural resource funds invest in companies that offer exposure to commodities. For example, a fund might invest in companies in the mining, drilling, timber or farming industries. What sets these commodity funds apart is that they’re exclusively natural resource-related; a commodity mutual fund that invests in foreign currencies wouldn’t fit into this category.
Combination funds can offer exposure to both commodities and commodities futures. For instance, you might come across a fund that invests in orange groves and orange juice futures. Since these funds include futures, they tend to carry more risk versus an index, commodity or natural resource fund.
# Commodity Funds Advantages
Similar to real estate, commodities typically have a low correlation to the stock market. That makes them a suitable investment for hedging against volatility. Commodity funds can help insulate your portfolio’s value against the market’s ups and downs.
Rising inflation can cause stock prices to fall but commodities can offer shelter to investors. If commodity prices rise due to inflation, commodity fund prices can also increase, yielding gains in the process.
One of the biggest advantages of Commodity Funds and ETFs is its simplicity. If you want to track a commodity index by yourself, you would have to purchase all the equities in this index basket. Commissions and the complexity of it make it hard to achieve your investing goals. Commodity Funds or ETFs on the other hand, offer you this with only one trade at one price.
# The Risks Involved
Any investment entails risk and commodity funds are no different. Commodities, in general, can be subject to wide price swings, which can directly affect your returns. Before you trade any commodity Funds or ETFs, make sure to first conduct plenty of research. Track the performance of the price of different commodities (like coal) and watch how some of the major commodity ETFs (like KOL, which tracks coal) react to different market conditions.
There is a lot of criticism that commodity ETFs consisting of futures contracts have a lot of difficulty tracking volatile commodities. However, once you do have a good understanding of how commodities and commodity ETFs interact, you can get started by including commodity ETFs and ETNs (exchange traded-notes) in your investing arsenal.
- Commodities Funds or ETFs help you achieve the exposure and portfolio diversity you wish with simplicity, by buying/selling a single product.
- Popular types of commodities include precious metals, oil and gas, livestock, agricultural products.
- There are different types of commodities funds, like index funds, futures funds, commodity funds. Each invests in different types of products and has a different overall objective.
- Commodity Mutual Funds are different than ETFs. Each has its own advantages and disadvantages, for your consideration.
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