Commodity Mutual Funds : Meaning, Features, Suitability & Types

What are Commodity Mutual Funds?

Commodity Mutual Funds are described as a type of fund that primarily invests in commodities and offers returns to investors based on the market performance of the commodity chosen by the AMC or fund manager. Commodity funds are those funds that invest in pure raw materials or primary agricultural products, known as commodities. These funds invest in precious metals like gold and silver, energy resources such as oil, natural gas, etc., and agricultural goods like rice, sugarcane, etc. Basically, there are two types of commodities that are traded, Agricultural Commodities and Non-Agricultural Commodities. Commodity funds also invest in the companies that are engaged in the production of these commodities; along with this, these funds also invest in commodity futures and options, and some commodity funds also invest in the stocks of companies, like gold funds, which invest in the stocks of companies engaged in gold mining. Some of the examples of commodity mutual funds are:

• AXIS Gold Fund
• LIC MF Gold ETF FoF
• ICICI Prudential Commodities Fund
• Tata Resources and Energy Fund Growth
• DSP Natural Resources and New Energy Fund – Growth

Features of Commodity Mutual Funds

1. Diversification: Commodity Mutual funds give you a mixed character for your portfolio. AMC’s which manages Commodity Mutual funds invest in different commodities which creates scope for diversification for investor, as they can experience the positive returns of different commodities while staying invested in a single commodity mutual fund.

2. Mitigation of Risks: Commodity Mutual Funds are secure as they mitigate the risk that is potentially present in investing directly in commodities, as commodity mutual funds invest in different commodities in different ratios which overcomes the risk factor.

3. Constant Income and Growth Rate: Commodity Mutual funds provide a constant income stream as any financial malfunctioning in one commodity class will not affect other classes of commodities, and there will be a continuous growth rate for the portfolio of investor.

4. Non-Biased: Comparing to general human tendency one can be biased over particular commodity, but Commodity Mutual funds employs experts and fund managers who manages these funds in order to use there expertise to provide better wealth maximisation to investors by using investing techniques and risk balancing techniques which eliminates the biasness towards any particular class of commodity.

5. Volatility: Commodity Mutual Funds tends to be volatile as commodities are very prone to price fluctuations. Also, as per the guidelines by SEBI a fund is required to invest 95% of total proceeds in commodities in order to be called as Commodity Mutual Fund. However, AMC’s try to adjust the price fluctuations by investing residual amount among other asset category.

Types of Commodity Mutual Funds

Commodity Mutual Funds can be categorised into the following categories:

1. Natural Resource Funds: These are those funds that are used to invest in companies and organisations that have access to the exploration of natural resources. The most popular among investors are gold, silver, oil, etc. Recently, investors have preferred renewable energy sources like wind energy due to recent technological advancements. Also, they often do not hold actual commodities or commodity futures, but they provide exposure to other commodity markets.

2. Basic/True Commodity Funds: These are those funds that predominantly invest in real physical assets. For example, metals are a naturally occurring resource. These funds are also referred to as basic since their pooled corpus directly purchases the commodities.

3. Future Funds: Commodity futures are a very popular option among investors, where the physical delivery of the commodity is possible only at a predetermined date. However, these are typically riskier on account of fluctuations in rates; there is a possibility of losing money if prices fall. Investors prefer this fund, as they are only interested in benefiting from price fluctuations rather than receiving actual physical delivery of commodities.

4. Index Funds: This is a fund that is marked against a standard market index, with the fund aiming to match or keep pace with the ongoing market trends. Commodity index funds are passive mutual funds in which assets are utilised to directly purchase commodities at market pricing based on benchmarks.

5. Combination Funds: A combination fund is a mix of the basic commodity fund and commodity futures. This type of fund combines commodity futures with the fundamental commodity fund. As part of their overall investment strategy, these funds invest in both basic commodities and commodity derivatives. Here, the volatility is controlled by traditional commodity investments; however, the risk is considerable with commodity futures.

Who Should Invest in Commodity Mutual Funds?

1. Investors who want to Stay Associated with the Commodity Market: Trading in commodities is complex as it involves a high degree of market research on the underlying commodity and the market trend, as well as time to educate oneself. Those who do not have the time to learn such skills might use commodities funds, which are normally run by competent fund managers and experts.

2. Investors who do not Expect Fixed Returns: These funds do not guarantee fixed returns in any specific way by the fund managers or AMC; therefore, the returns generated might vary. For this reason, commodities mutual funds are inappropriate for those investors who are looking for assured appreciation of an investment or fixed returns from their portfolio.

3. Investors having High-Risk Appetite: Commodity mutual funds are a wise investment option only for those investors who do not mind taking risks, do not have a set time frame in mind for receiving optimal returns, and can stay invested for a longer time horizon.

4. Invetsors who want to Diversify their Portfolio: These investments are appropriate for people who have a substantial amount of cash, want to diversify their portfolio, and want to add another class of asset to their holdings.

Advantages of Commodity Mutual Funds

1. Allows Diversification: Commodity mutual funds invest in different classes of commodities, which allows investors to diversify their portfolios across different classes of commodities. Commodities and commodity stocks provide returns that differ from other stocks as compared to a portfolio with assets in a single line, which can help you better manage market volatility. However, diversification of portfolios does not ensure a guarantee of profits, as returns depend on market forces.

2. Potential Returns: Individual commodity prices fluctuate due to factors like supply and demand, exchange rates, inflation, and other economic factors. A rise in commodity prices will have a positive impact on the stocks of companies in related industries and can lead to increased investor returns.

3. Hedge Against Inflation: The majority of commodities funds function as an inflation hedge for investors by providing returns that are consistent with worldwide shifts. Therefore, investments in commodities operate as a hedge against inflation, as they offer protection against a currency’s declining buying value as a result of inflation.

4. Provides Investment Flexibility: Investors have the choice to use commodities funds to achieve their financial objectives from their portfolio. Investors can use commodity funds to achieve their short-term and long-term investment objectives by investing in a variety of commodities. AMC allows investors to choose their portfolios depending on personal taste, with various needs being met by different funds.

5. Planned Investment: The majority of commodities funds are run by well-known AMCs and fund managers who are knowledgeable about the market and experts in this field. This helps investors boost their returns by considering such wise investments.

Disadvantages of Commodity Mutual Funds

1. High Volatility: Subject matter for commodity mutual funds is commodity and they are prone to market fluctuations. Commodities like Oil, gold are highly volatile and any major price swings or fluctuations could have material impact on the portfolio.

2. Market Affected by Speculation: One of the main reason for high volatility of commodity prices is the high number of speculator who takes part in the trading of these commodities. As commodities are highly volatile, there ups and downs attracts those who seek short-term profits and such mass movements of these speculators leads to the price fluctuation on a higher side.

3. Does not Offers Flexibility: Commodity Mutual Funds have to invest 95% in commodities, and this might impact the flexibility which other funds offers to investors. Also it is on the AMC and fund manager in which commodities they want to invest and any option to switch between commodities is not given to the investors.

4. Taxation on Short-Term Holding: If an investor holds a commodity mutual Fund for a short-term duration, say 1 year, he/she shall be liable to pay tax as per their applicable income tax slab rates, and also no benefit of indexation will be available.

5. No Guarantee of Success: The selection of class of commodity is based on the decision by the fund managers or AMC, so the returns will also differ as per the invested category of commodity. So, the fund doesn’t provide sure shot guarantee that it will turn into a successful investment option for the investor, also there is no defined proportion of commodities in which AMC’s or fund manager has to invest.

Risks Associated with Commodity Mutual Funds

Although there are several benefits associated with commodity mutual funds, due to their price fluctuation, the following risks can be identified while investing in commodity mutual funds:

1. Principal Risk: Commodity prices tend to be extremely volatile, and the commodities industry can be significantly affected by any world events, import controls, government regulations, and economic conditions all over the globe, all of which can have an impact on commodity prices. There is a chance that investors could lose significant value from their holdings.

2. Volatility: Mutual funds that track a single sector or commodity will possess higher volatility than the average. When a commodity fund invests in futures, options, or other derivative instruments, it can further increase the volatility of the investor’s portfolio.

3. Foreign and Emerging Market Exposure: Along with the other risks associated with commodity funds, these funds also carry the risks that go along with investing in foreign and emerging markets, as the risk can be caused by volatility caused by political, economic, and currency fluctuations.

4. Asset Concentration: Although commodity funds can play a role in the diversification strategy of any portfolio, they are considered non-diversified as they have to invest a significant portion of their assets in fewer individual securities that are generally concentrated in 1 or 2 industries focusing on commodities. So even a small change in the market value will cause greater fluctuations in the share price than would have occurred in a more diversified fund.

5. Other risks: Funds that focus on commodities use futures contracts to track an underlying commodity or commodity index, due to which trading in these types of securities is speculative and can be extremely volatile. This causes a significant decline in the performance of a fund. Due to price fluctuation, the result can be either negative or positive, depending on the market performance.