Your Questions Answered: What are the benefits and risks of commodity mutual funds for my investments?

Q. Me and my wife have been investing in large-cap index mutual funds for the past 10 years. We now intend to diversify our investment and have thought of investing in sectoral mutual funds, specifically commodity mutual funds. Can you please elaborate on the pros and cons of commodity mutual funds.

C.K. Tiwari, Noida, Uttar Pradesh

Introduction

Before we understand what commodity mutual funds are, let’s understand sectoral mutual funds. Sectoral mutual funds invest exclusively in companies belonging to a specific sector or industry. 

For example, you can find sectoral mutual funds dedicated to industries like healthcare, technology, financial services, energy, real estate, or consumer goods. As per Securities and Exchange Board of India (SEBI) regulations, sectoral mutual funds are mandated to invest at least 80% of their corpus in the sector or theme of their choice. By concentrating investments within a specific sector, these funds allow investors to capitalise on the growth potential of industries they believe will perform well in the future.

Commodity mutual funds

Commodity mutual funds are a unique investment vehicle that allows investors to gain exposure to various commodities such as metals, oil, agricultural products, and more. These funds are designed to provide diversification and act as a hedge against inflation and market volatility.

These funds can invest directly in physical commodities, commodity futures contracts, or shares of companies involved in commodity-related industries. The primary goal of commodity mutual funds is to provide investors with returns that are linked to the performance of the underlying commodities.

Benefits of commodity mutual funds

Commodity mutual funds have been gaining traction among investors looking to diversify their portfolios and protect against market volatility and inflation. The following are the key benefits of commodity mutual funds:

1. Diversification: One of the primary benefits of commodity mutual funds is portfolio diversification. Diversification involves spreading investments across various asset classes to reduce risk and improve returns. By including commodities in their investment portfolio, one can achieve a higher level of diversification. Commodities often have a low correlation with traditional asset classes like stocks and bonds. Adding commodities can help mitigate the impact of poor performance in other asset classes. A diversified portfolio is more resilient to market fluctuations and economic downturns.

2. Protection against inflation: Commodities are known for their ability to act as a hedge against inflation. Inflation erodes the purchasing power of money, but commodities tend to retain their value or even appreciate during inflationary periods. Commodities like gold and silver have historically performed well during inflation. Investing in commodity mutual funds can help preserve the real value of your investments. Commodities such as oil and agricultural products also tend to increase in price during inflationary times.

3. Hedge against market volatility: Commodity mutual funds can provide a hedge against market volatility. While traditional asset classes like stocks and bonds can experience significant price swings, commodities often move independently of these markets. Commodities’ prices are influenced by factors such as supply and demand dynamics, geopolitical events, and weather conditions. Including commodities in your portfolio can reduce overall volatility and enhance stability. Commodities’ performance can be counter-cyclical to equities, providing a buffer during stock market downturns.

4. Exposure to global growth: Investing in commodity mutual funds allows you to gain exposure to global economic growth. Commodities are essential for industrial production, infrastructure development, and consumption, making them closely tied to global economic activity. Demand for commodities like metals, energy, and agricultural products increases with economic growth. Investing in commodity mutual funds can benefit from rising commodity prices driven by global demand. Commodities are a way to tap into emerging markets’ growth potential, where demand for raw materials is often higher.

5. Professional management: Commodity mutual funds are managed by experienced fund managers with expertise in the commodities market. These professionals use their knowledge and research to make informed investment decisions, aiming to maximize returns for investors. Professional fund managers analyse market trends, supply and demand factors and geopolitical events to make investment choices. Active management can help navigate the complexities of the commodities market and capitalise on opportunities. Investors benefit from the fund manager’s expertise without needing in-depth knowledge of commodities.

6. Liquidity: Commodity mutual funds offer liquidity, allowing investors to buy and sell their shares easily. Unlike direct investments in physical commodities or futures contracts, which can be less liquid, mutual funds provide a convenient way to invest in commodities. Mutual funds are traded on stock exchanges, providing daily liquidity. Investors can access their funds quickly in case of emergencies or changes in financial goals. The liquidity of mutual funds makes them a flexible investment option.

7. Cost-effective: Investing in commodity mutual funds is a cost-effective way to gain exposure to commodities. Direct investments in physical commodities or futures contracts can involve high transaction costs, storage fees, and other expenses. Commodity mutual funds pool investors’ money, reducing individual transaction costs. Management fees for mutual funds are typically lower than the costs associated with direct commodity investments. Investors can benefit from economies of scale, as mutual funds can negotiate better terms with brokers and other intermediaries.

8. Access to a wide range of commodities: Commodity mutual funds provide access to a broad spectrum of commodities, including precious metals, energy resources, agricultural products, and industrial metals. This variety allows investors to diversify their exposure within the commodities market. Investors can choose funds that focus on specific commodities or a diversified basket of commodities. Access to various commodities helps spread risk and capture opportunities across different sectors. Some mutual funds track commodity indices, providing broad-based exposure to the commodities market.

Cons of investing in commodity mutual fund

While commodity mutual funds offer numerous benefits, it’s crucial to also consider the potential drawbacks before making an investment decision. In this detailed blog, we will explore the cons of investing in commodity mutual funds to provide a balanced perspective.

1. Market risk: The performance of commodity mutual funds is closely linked to the performance of the underlying commodities. Any adverse developments in the commodities market can negatively impact the returns of these funds. Commodity mutual funds are subject to the same risks as the commodities they invest in. Economic downturns, geopolitical tensions, and changes in government policies can affect commodity prices. Investors may face periods of poor performance if the commodities market underperforms.

2. Regulatory risk: Commodity markets are subject to various regulations and government policies that can impact the trading and pricing of commodities. Changes in regulations can introduce uncertainty and affect the performance of commodity mutual funds. Regulatory changes can lead to increased compliance costs for fund managers. Government interventions, such as tariffs and trade restrictions, can influence commodity prices. Investors may face uncertainty due to the evolving regulatory landscape.

3. Complexity: Investing in commodities can be more complex compared to traditional asset classes. Understanding the factors that influence commodity prices and the mechanics of futures contracts can be challenging for individual investors. Commodity markets require specialised knowledge and expertise to navigate effectively. The complexity of commodity investments may deter inexperienced investors. Investors need to conduct thorough research and stay informed about market developments.

Key considerations before investing in commodity mutual funds

Commodity mutual funds can be an attractive investment option, offering diversification, protection against inflation, and exposure to global growth. However, it’s essential to conduct thorough research and consider several factors before making an investment decision.

1. Understand the fund’s investment strategy: Commodity mutual funds can have different investment strategies, such as investing in physical commodities, commodity futures, or companies involved in commodity-related industries. Understanding the fund’s investment strategy is crucial to align your investment with your financial goals and risk tolerance. Determine whether the fund invests in physical commodities, futures contracts, or commodity-related companies. Assess how the investment strategy aligns with your risk tolerance and investment objectives. Consider whether the fund is actively or passively managed.

2. Analyse historical performance: Reviewing the historical performance of the commodity mutual fund can provide insights into its past returns and risk profile. While past performance is not indicative of future results, it can help you understand how the fund has performed under different market conditions. Examine the fund’s historical returns over various periods (e.g., 1-year, 3-year, 5-year). Compare the fund’s performance to relevant benchmarks and peer funds. Consider the consistency of the fund’s returns and its performance during market downturns.

3. Evaluate the fund manager’s expertise: The expertise and track record of the fund manager play a critical role in the success of a commodity mutual fund. A skilled and experienced fund manager can make informed investment decisions to maximize returns and manage risks. Research the fund manager’s background, experience, and track record. Assess the manager’s expertise in the commodities market and their approach to managing the fund. Consider the stability and tenure of the fund management team.

4. Assess the fund’s expense ratio: The expense ratio represents the annual fees and expenses charged by the mutual fund, expressed as a percentage of the fund’s assets. A higher expense ratio can erode your investment returns over time. Compare the expense ratio of the commodity mutual fund to similar funds in the same category. Consider whether the fund’s performance justifies its expense ratio. Be aware of additional costs such as transaction fees and sales loads.

5. Understand the fund’s risk factors: Commodity mutual funds are subject to various risks, including price volatility, market risk, liquidity risk, and regulatory risk. Understanding these risks is essential to make an informed investment decision. Identify the specific risks associated with the commodities in which the fund invests. Assess the fund’s risk management strategies and how they address potential risks. Consider your risk tolerance and investment horizon when evaluating the fund’s risk factors.

6. Evaluate liquidity and redemption policies: Liquidity refers to the ease with which you can buy or sell shares of the commodity mutual fund. It’s important to understand the fund’s liquidity and redemption policies to ensure that you can access your investment when needed. Review the fund’s redemption policies, including any restrictions or fees for early withdrawals. Consider the liquidity of the underlying commodities and how it affects the fund’s liquidity. Assess the impact of market conditions on the fund’s liquidity.

7. Review fund documentation: Before investing in a commodity mutual fund, it’s essential to review the fund’s prospectus and other documentation. These documents provide detailed information about the fund’s investment objectives, strategies, risks, and fees. Carefully read the fund’s prospectus to understand its investment approach and risk factors. Review the fund’s annual and semi-annual reports for insights into its performance and holdings. Check for any recent changes in the fund’s investment strategy or management team.

Performance and returns

Many mutual fund houses in India offer commodity mutual funds. Below we have listed the top 3 commodity mutual funds based on their past 3-year return (CAGR).

Note: All data obtained from AMFI website as on 17th March 2025.

Past returns are not indicative of future performance.

Conclusion

Investing in commodity mutual funds requires careful consideration of various factors, including the fund’s investment strategy, historical performance, manager’s expertise, expense ratio, risk factors, liquidity, tax implications, and fund documentation. By conducting thorough research and evaluating these key considerations, you can make informed investment decisions that align with your financial goals and risk tolerance. As with any investment, it’s essential to stay informed and regularly review your investment to ensure it continues to meet your objectives.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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