Commodities are the “hot” new investment. They sure sound sexy. And a lot of sophisticated money such as university endowments and hedge funds are pouring money into this sector. Fortunately there are several well-established mutual funds are targeted towards this investment class. Before investing though, one must completely understand the basics.
What are commodities? They are basic materials used in other products. This includes everything from grains, coffee, sugar and livestock to minerals and metals. They are a popular choice for several reasons. They act as an excellent hedge against inflation because their prices to tend rise in lockstep with it. They can act as financial diversification because their investment returns aren’t entirely correlated with equities or bonds. These two reasons are why commodities should be a part of every diversified investment portfolio.
There are some additional fundamentals though as well that make commodities an interesting from an investing perspective (not just a diversification one) . Many experts say that the long-term look for them is excellent because of the rapidly growing emerging market economies like India and China. Industrialization requires many basic materials (steel, copper, etc) for things like construction, cars and appliances. Plus the millions of people in poverty are joining be consuming more and thus drive demand for agricultural goods. There are arguments as well that many types of commodities are at or near “peak” production capacity. The most popular one is oil. But some people say the same exists for agricultural goods (hence why so many oil countries are making “land grab” agreements with poor African countries.)
There are several ways to get exposure to this type of market. You could technically buy commodities on the spot market (say a warehouse full of coffee beans). But this is really something that is best left to experts. Most investors trade futures contracts because it is far easier. But this is something that is best left to advanced investors as pricing is very fickle and volatile.
The best way for typical retail investors to gain exposure are top commodity mutual funds. There are two big ones. The first is the Oppenheimer Real Asset Fund (QRAAX). The second is Pimco Commodities Real Return Fund (PCIRX). Both Oppenheimer and Pimco are well-established asset management firms with many decades of experience.
The two differ in several ways. Pimco invests in US government inflation-protected bonds, while Oppenheimer does not. Thus the Pimco fund is more insulated towards inflation. Pimco also caps energy holdings at 33% which means industrial metals make up a larger part of its portfolio.
Both funds are relatively expensive, especially considering their size. The Pimco fund has $13 billion in assets but still has an expense ratio of 1.24%. The Oppenheimer fund is even higher. Both these funds have high turnover as well, meaning a very high tax liability.
Another alternative are commodity ETFs, which we will be covering on this site very shortly.