Commodity mutual funds

Commodity mutual funds provide exposure to the price changes of raw materials, such as agricultural goods (corn, cotton, wheat, etc.), natural resources (oil, natural gas, etc.), and metals (gold, silver, etc.).

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What are commodity mutual funds?

Commodity mutual funds invest in commodities and are frequently structured in one of three ways:

  • Equity holdings in commodity-related companies

    Commodity mutual funds will hold equities in commodity-related companies such as those of agricultural, energy or mining companies.

  • Futures-based funds

    The second structure for commodity mutual funds is futures contracts. These trade on exchanges, similar to stocks and bonds, and don't require storage like a physical commodity does. When a futures contract approaches the delivery date, the holder will typically "roll" that contract in exchange for another contract of the same commodity to be delivered further in the future.

  • Combination of equities and futures

    Finally, some funds will hold a combination of both equities of commodity-related companies and commodities futures contracts.

What are the pros and cons of commodity mutual funds?

  • Pros

    Portfolio diversification
    Many investors turn to commodities for diversification as commodity returns will typically move in the opposite direction of stocks and bonds due to the low or negative correlation between the three asset types.

    Inflation protection
    Investors also use commodities to potentially provide a level of protection against inflation due to the positive correlation commodities have with inflation, generally appreciating when inflation rises.

  • Cons

    Volatility
    Investments in commodities can be volatile. Allocating too much of your portfolio to commodities may undermine the diversification benefits.

What is market contango and backwardation?

Contango occurs when investors are willing to pay a premium today to be sure of the price they'll get in the future. If the market for a particular commodity experiences strong, persistent contango, a fund that buys futures contracts on that commodity will perform worse than the spot price of the commodity over time as lower-valued, near-term contracts are consistently replaced with higher-valued, longer-dated contracts.

Backwardation is the opposite of contango. It means that the futures price is lower than the spot price. In backwardation, contracts tend to increase in value as they approach maturity.

Most actively managed mutual funds seek to mitigate contango and backwardation issues by shifting their futures contracts investments to different parts of the futures curve based on the current market dynamics, such as moving into mid-curve contracts and away from near-term contracts when a market is in contango.

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