Commodity Mutual Funds – Types, Benefits and Things to Know before Investing

Investors looking to diversify their portfolio beyond stocks and bonds can invest in commodities. This can minimise one’s portfolio volatility as the commodity market has historically shown a low  correlation to the equity and debt markets. Moreover, such investments can be used as an inflation-hedge.

One can invest in various commodities through commodity mutual funds in India. This allows regular investors to  get benefits from the commodities’ market growth.

What are Commodity Mutual Funds?

Commodity fund is a  mutual fund that invests in these highly-traded commodities. Although there is no SEBI recognized category of commodity mutual funds,  SEBI’s circular released in 2019 has allowed mutual funds to invest in exchange-traded commodity derivatives, and in gold and silver. 

Commodity funds usually focus on one or more underlying assets with the aim of benefiting from the trading of various commodities. Returns from such funds depend largely on the market demand and price changes of commodities. 

How does Commodity Trading Work?

A commodity is any basic raw material that has an economic value and is traded for money. Gold, oil, coffee, oil, silver, food grains, livestock, etc., are some of the most commonly traded commodities. Commodities are used to manufacture finished products and are interchangeable with similar goods. 

Commodities of a similar type are mostly uniform in quality, which allows ease of trading. Their quality needs to meet a minimum standard, so that they can be easily traded on exchanges. Investors and traders can exchange commodities directly in the cash market or through derivatives such as futures and options (F&O).

In India, most commodity investment takes place via futures and options. Commodity trading can be done through registered exchanges like the Multi Commodity Exchange (MCX), Indian Commodity Exchange (ICE), National Multi Commodity Exchange (NMCE), National Commodity and Derivatives Exchange (NCDE), etc.

Returns from commodity investments are largely influenced by demand and supply. Traders leverage the instability in prices to generate profits. However, many people prefer to invest via commodity mutual funds in India due to the volatility and risks of commodity F&O trading. 

What are the Different Types of Commodity Mutual Funds?

The following are the different types of commodity funds based on investment objective and strategy:

1. Index funds: These are passively managed mutual funds that track a commodity index. Such funds aim to replicate the performance of their benchmarks with minimum tracking error. 
2. Future funds: These mutual funds invest in commodities through futures contracts. A future contract acts as an agreement where the buyer buys or sells a specific quantity of a commodity at a certain price and date. These funds hold the highest risks among all other commodity mutual funds in India.
3. Basic commodity funds: Also called ‘true’ commodity funds, these funds directly invest in naturally occurring commodities such as metals and oil. 
4. Combination funds: These commodity funds invest in both commodity futures and basic commodities. As they invest in both high-risk futures and less volatile commodities, combination funds offer a better balance of risks and returns.
5. Natural resources funds: These funds invest in companies dealing with natural resources. Petroleum, minerals, gold, silver, etc., are some of the resources that are considered for investment. Nowadays, some commodity mutual funds also invest in renewable energy.

Also Read: How to Invest In Silver: Top Ways of Buying and Selling It

Benefits of Investing in Commodity Mutual Funds

The following are some of the reasons why you may consider investing in commodity mutual funds in India:

• Adds a unique asset class to your portfolio

Any experienced investor will know the importance of diversification to mitigate the effects of market volatility. By investing in commodities, one can add a unique asset class to his/her portfolio that does not correlate with the equity or debt market.

• Fund manager’s expertise

As mentioned before, the commodity market in India is highly volatile and risky. In addition, a lack of knowledge among investors makes commodity trading very challenging for most regular investors. Thus, you can turn to commodity mutual funds where fund managers experienced with commodity trading invest on your behalf.

• Protection against market downturns 

Prices of some commodities like gold and silver are not dependent upon  market trends. Moreover, returns from these commodities increase when the stock market is performing poorly. That is why commodity mutual funds tend to offer high returns in a bearish market. 

• High return potential

When the demand for certain goods is high or their supply is low, their prices tend to grow significantly. For example, when there is a global shortage of petroleum, its market value becomes very high. By investing in the best commodity funds in India, you can make significant profits during certain geopolitical events.

• Used for hedging against inflation

The returns from commodities usually correlate with the rate of inflation in the economy. Moreover, the generated returns help to mitigate losses from devaluation in the domestic currency. These factors make commodity mutual funds suitable for hedging against inflation.

Also Read: How to Avoid Losses during Commodity Trading

Risks of Investing in Commodity Mutual Funds

The following are some of the inherent risks involved with investing in commodity mutual funds:

• Highly volatile

Commodity Mutual funds that track a single commodity can exhibit high volatility. Also, funds that use futures, options, or other derivative instruments can further increase volatility. 

• Returns depend on the commodity’s price

The returns from commodity mutual funds in India are highly dependent on the price of the underlying commodity. If the prices fall, the fund will book negative returns. In addition, commodities suffer from a lack of sufficient price discovery, leading to irrational pricing and low liquidity.

• Affected by complex geopolitical factors

Since commodities are freely traded around the world, their prices are highly dependent on global supply and demand. This also means they are sensitive to unpredictable geopolitical risks. For example, if a country importing gold has a geopolitical dispute with an exporter country, the prices would drastically change.

We have seen the same scenarios in the crude oil prices in March 2022 due to ongoing Russia Ukraine war . 

Also Read: Portfolio Diversification with Commodity Derivatives

Who Should Invest in Commodity Mutual Funds?

The following investors may find commodity mutual funds suitable for investing:

• Since the prices of commodities can change overnight and the market is very volatile, only investors with a high-risk appetite will want to consider commodity mutual funds.
• Investors with a long-term investment horizon,as they may have to wait indefinitely till they get their desired returns. 
• Young investors may consider these high-risk investments. t Investors near retirement should avoid investing in these, as they do not offer predictable or stable returns. If you lack the knowledge and experience to trade directly in the commodities market, you can invest through commodity mutual funds. Since with commodity funds, you can leverage the expertise of the fund manager.

Things to Consider before Investing in Commodity Funds

Like any other mutual fund, there are certain factors to consider before investing in commodity mutual funds:

• Cost of fund

All mutual funds levy some fees and charges called the expense ratio. This is an annual fee which is charged for managing and operating a mutual fund. Another applicable charge is the exit load, which is levied upon premature exit. You should look for the lowest costs when choosing a commodity mutual fund in India.

• Risk tolerance

Before investing in any mutual fund, you should evaluate how much risk you can bear. Since risks and returns are directly proportional, you can consider investing in commodity funds if you are looking for substantial returns. Your age and financial status also have an impact on  your risk tolerance.

• Investment objective

Whether you have short-term goals such as buying a car or long-term goals like a retirement plan, always assess your financial objective before making any investment. 

Also Read: Index Fund vs. ETF: What’s the Difference?

List of Top Commodity Funds in India

Now that we have a detailed understanding about commodity funds, below are the most popular  mutual funds for 2022. 

*Returns data valid as of October 3, 2022. 

Also Read: 5 Reasons to Trade in Commodities

Concluding Remarks

If you want to invest in highly-tradable commodities, commodity mutual funds in India could be one of the best ways to invest. They offer a relatively safer way to invest in the highly-volatile commodities market without having a prerequisite of  extensive knowledge. They also offer a unique element of diversification to your portfolio. 

FAQs about commodity mutual funds