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.

Rogers graduated from Yale University in 1964 and got a second degree from Oxford in 1966. After a brief stdnt in the army he joined Wall Street. Rogers co-founded the Quantum Fund in 1970. In ten years, the fund returned 4200% while the S&P gained 47%. This amazing returns is why he is one of the biggest name in the commodities business.

In 1980 he retired and traveled around the world on his motorcycle. Since then he has hosted several television shows. He founded the Rogers International Commodity Index in 1998.

Many investors, especially those putting money into commodity futures, take inspiration from him. So what lessons can we take from his life? For one, he has written three books on investing which are widely available.

Second, he publicly bullish on two big ideas. One of them is agriculture. He sees the increasing food demands because of the population explosion and increasing wealth of the developing world. He has even bought into partnerships investing in agriculture. Second, he has taken a very strong stance on the growtth of Asia and even moved to Singapore. Keep these two ideas in mind when investing. For those wanting to just diversify their portfolio somewhat into commodities, they should consider buying into the Roger commodity fund (his index fund).

One of the best options is just simply buying an ETF. What makes them great is that they are freely-traded. You don’t need to sign up directly with the mutual fund company to buy them. You can just buy a share of the fund like you are buying a stock of a company. There are several of them available; the biggest and most reputable companies include PowerShares and iShares. They are also good in that that most of them are passively managed (designed to match an index and thus low cost) and certain tax benefits that regular mutual funds do not have.

To buy an ETF just log into your stock brokerage account and buy one. Do some internet research to find an ETF that particularly suits your needs. Try using a site like Seeking Alpha or Yahoo Finance.

Don’t despair if you don’t already have online stock broker. The market is extremely competitive. Most brokers offer big incentives for new customers; everything from discounted or free stock trades to signup bonuses. Be sure to look out for them.

It is recommended that unless you are very experienced in a financial markets to buy a broad-based commodity fund that invests in several securities. Commodity markets are frequently are significantly more volatile than stock or bonds in general. So while you might think oil will make a great long term investment, there might be a short term “dip” that could have a huge effect on your portfolio. Like with any financial instrument, diversity is key.

The original way that was used by investors such as George Soros was investing in futures. This was great, because one could make a financial bet on the movement on the price of a bushel of corn without actually buying the corn. However, this might not be a good choice for most investors. These products are highly leveraged. A relatively small fluctuation in commodity prices could mean a wide swing in prices. Unless you are an expert and plan on dedicating a significant amount of time researching your investments, it is highly recommended not to start with futures.

One of the most popular and highly recommended options is the PowerShares DB Commodity Index Tracking Fund (stock symbol DBC). It is advised byDeutsche Bank, one of the largest banks in the world.

What exactly is this fund? It’s an ETF. This means you can buy a share of it like you were buying a stock. You don’t need to set up a special account with Deutsche Bank to set up an account. This is great as it is extremely convenient. There are also certain tax advantages as well. It is also linked to an index, meaning that it is extremely low-cost because they do not hire active management.

The composition of the index is fairly straightforward. The fund is 35% crude oil, 20% heating oil and 10% to 12.5% each of aluminum, gold, corn and wheat. Every year the ETF is rebalanced.

As you can see, by buying into this fund you get a broad exposure towards various important commodities. This is exactly what many investors are looking for. However, some might want to be more speculative. If you think the price of corn is ready to explode and want to put money on it, this particular ETF would actually not make a good choice because only around 10%-12.5% of your money will actually go into it. There are a number of other ETFs that are further specialized. Consider purchasing them. In some ways you could basically run your own mini commodity hedge fund, betting on the price of movements from everything from gold to pork bellies.

But what if you want someone else to do the investing for you? Commodity markets are extremely complex because prices are affected by so many factors. But with great volatility comes great opportunity; famous commodity investors such as Jim Rogers have made a killing in the market. For those wanting an actively-managed commodity mutual fund there are several options. Claymore Delta Global Hard Assets Fund might be a good choice. This particular fund invests in so-called “hard assets” such as precious and hard metals. There is also Claymore Delta Global Agribusiness Fund, which does the same to agricultural commodities. There are other fund family choices out there.

As you can see, there are many commodity investment options out there. The “best” commodity mutual fund in fact differs based on the type of investor. We personally believe for the vast majority of investors looking to add some commodities to their portfolio that the DB commodity index is the best option. It’s not as “sexy” as futures or actively-managed funds but it is low cost and low maintenance.

There are several options to personal investors wanting to put some of their portfolio into commodities . Hedge funds are the most famous option. Some of the funds have had extremely high returns in recent years. But only the extremely wealthy are allowed to buy into these funds. And many of the best-performing ones are closed to new investors. Commodity index funds are another option. They are low cost because they do not have to pay the salaries of investment managers. But they are merely designed to track an index. This is good option for investors who are primarily looking to diversify their portfolio and add an asset class that isn’t correlated with stocks or bonds. Commodity mutual funds might be the best option. They are open to everyone. They are not murky like hedge funds. And they have an active management that have the ability to exploit market inefficiencies and take advantage of the trends previously mentioned.

Commodities are interesting because their performance is often not-correlated with stocks and bonds. In plain english, commodities can perform well when other parts of your portfolio are floundering. A properly diverse portfolio will help you weather crashes in various investmet markets.