How do Mutual Funds invest in Commodities?
2 june, 2025
Synopsis:
Commodity mutual funds help you invest in commodities like gold, silver or oil without physically buying them. They use investment options like ETFs, company stocks, or futures to follow price changes.
These funds are managed by experts who aim to balance risk and returns. You can choose from different types based on what you want, whether it is pure commodity exposure or a mix.
They are easy to start with, offer good liquidity, and help protect your money during inflation. But you should be aware of market ups and downs and always invest as per your risk appetite.
Many investors look for ways to participate in commodity markets when they see potential for growth in commodities like gold, silver, or crude oil. Commodity mutual funds provide a convenient way to invest in these markets without the complexities of directly trading or storing physical commodities. These funds are regulated by SEBI, and fund houses create these schemes to help investors tap into cyclical opportunities, hedge against inflation, and add diversification to their portfolios.
How Do Mutual Funds Invest in Commodities?
Mutual funds can invest in commodities through various approaches. While some funds invest directly in physical commodities like gold and silver, others gain exposure through commodity-related securities, futures contracts, or stocks of companies involved in commodity production. These funds are managed by professionals who track commodity trends and allocate capital in a way that aligns with the fund's objective.
These funds are characterised based on their investment focus strategies and are as follows:
Basic or True Commodity Funds
These funds invest in commodities like metals, which are mostly physical assets. Gold funds, for example, often hold physical gold through Gold ETFs or Gold Deposit Schemes. These funds closely track the actual prices of these commodities and are ideal for investors looking for direct commodity exposure without personally managing physical assets. Natural Resource Funds
Instead of buying commodities, these funds invest in companies that produce natural resources, such as oil drilling firms or mining companies. Returns depend on how these companies perform, often benefiting when commodity prices rise.
Commodity Futures Funds
These funds use future contracts to bet on the price movements of commodities. Since they don’t hold the actual commodity, they are riskier and more volatile, but can deliver higher returns if the market moves in the right direction. The NAV of these funds can rise or fall dramatically based on the call made by the fund manager.
Combination Funds
These offer a balanced approach by mixing different types of investments, like futures, physical commodity ETFs, and commodity-related company stocks. They reduce risk by spreading investments across multiple sources linked to commodities.
Commodity Index Funds
Index funds are passively managed. The fund manager uses the corpus to buy a commodity at the standard rates based on the benchmark.
Advantages of Investing in Commodity Mutual Funds
Inflation Hedge
Commodities often rise in value when inflation increases. Investing in commodity mutual funds can help protect the real value of your investment during inflationary periods.
Portfolio Diversification
Adding commodities to your mutual fund portfolio reduces dependence on equity and debt markets. This can help balance risk and improve overall returns over the long term.
Professional Management
Commodity markets are volatile and influenced by global events. In mutual funds, expert fund managers make decisions based on research, risk analysis, and global price trends.
Low Entry Barrier
You do not need large capital or trading accounts to invest in commodities. With mutual funds, you can start small and gradually increase your exposure as per your financial plan.
Easy Liquidity
Unlike physical assets such as gold or agricultural goods, mutual funds are easy to buy and sell. Most commodity mutual funds offer daily liquidity, which means you can redeem your units when needed.
Tenure Agnostic Commodity mutual funds allow you to invest for any time period based on your financial objective, without fixed lock-in periods commonly associated with certain physical commodity investments.
Risks of Investing in Commodity Mutual Funds
Price Volatility: Commodity markets can experience extreme price fluctuations due to global supply-demand imbalances, geopolitical tensions, weather conditions, or economic shifts. This volatility can lead to significant and sometimes unexpected swings in fund returns.
Market Speculation Impact: Many commodity markets, especially futures markets, are driven by speculative trading rather than just fundamental demand. This can cause prices to deviate from underlying economic realities, creating additional unpredictability for fund performance.
Inflation/Deflation Risk: While commodities typically serve as inflation hedges, sudden deflationary periods can adversely affect commodity prices and returns. This dual-edged relationship with economic cycles requires careful timing.
Regulatory and Policy Risks: Government policies, trade restrictions, import/export regulations, and environmental laws can dramatically impact commodity markets. Changes in these policies can create sudden shifts in commodity prices that are difficult to anticipate.
Fund Manager Dependency: Returns heavily rely on the fund manager's ability to navigate complex commodity markets. Poor timing decisions or strategy choices can lead to underperformance even when the underlying commodities perform well.
Contango and Backwardation Effects: Futures-based commodity funds face unique challenges related to the pricing structure of futures contracts. When markets are in contango (future prices higher than spot prices) or backwardation (future prices lower than spot prices), fund returns can be affected regardless of actual commodity price movements.
Currency Risk: Since most commodities are priced in US dollars or other international currencies, exchange rate fluctuations can significantly impact returns for Indian investors, adding another layer of volatility.
Liquidity Risk in Underlying Assets: Some commodity markets, particularly for more exotic commodities, may lack sufficient trading volume, potentially creating liquidity issues when fund managers need to execute large trades.
Sector Concentration Risk: Funds focusing on specific commodity groups (like precious metals or energy) can face concentrated exposure to sector-specific challenges, limiting diversification benefits.
Commodity mutual funds let you invest in important raw materials like gold, oil, or wheat without actually buying or storing them. They help add variety to your portfolio and can protect your money from rising prices. However, like any investment, they come with some risks, so it is important to invest in funds based on your objectives and how much risk you are comfortable taking.
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