Are commodity mutual funds for you?

Till about a year ago prices of commodities like gold, copper, nickel, crude oil were rising rapidly but the economic slowdown of the last year has sent them spiralling downwards like most other investment products. However once the world economy starts growing, commodity prices will likely rise again so this may not be a bad time to invest some of your money in commodities.

One way of doing this is to invest in commodity futures but that can be quite risky especially for novice investors. Futures are highly leveraged investments. This means that you can lose a lot of money quickly if you bet wrong.

Furthermore, futures trading involve complications like margins and mark-to-market which have to be mastered before you begin trading.

The bottom line is that investing in commodity futures is not suited for the novice investor.

Another option is gold which you can buy either by buying the physical metal or through gold exchange traded funds (ETFs). However in many ways gold behaves differently from other commodities.

For example in a troubled economy like the current one investors often rush to buy gold driving up prices because gold is perceived as a safe investment. However when the economy recovers gold may give only average returns.

By contrast most other commodity prices (like say oil prices) move according to global demand and supply and are likely to rise when the economy recovers and industrial and consumer demand increases.

Perhaps the best way to invest in commodities is through a commodity-based mutual fund. These are mutual funds which invest in companies which are in a commodity-related business; for example oil and gas, metals and so on.

The idea is that as commodity prices increase the profits of these companies and therefore their share prices will also rise. Thus the investor is indirectly investing in commodities but in a relatively safe and diversified way.

The first mutual fund of this kind was the SBI Magnum Comma Fund which was launched in 2005. It invests mostly in the stocks of commodity-related businesses with some of the money going to debt and money-market instruments. The fund has an entry load of 2.25 per cent and no exit load for investments that are held for more than 12 months.

In the last couple of years many other such funds have been launched and today there are more than ten of them. For example the Reliance Natural Resources Fund invests in commodity-based companies not just listed in India but in several stock markets around the world.

Another option is the Birla Sun Life Commodity Equities Fund which gives a choice between three plans: a multi-commodity plan investing in a wide range of commodity companies, a precious metals plan and an agri plan for agro-based businesses.

Of course commodity-based funds like most funds have performed poorly in the last year losing more than 30 per cent in that period. However this means their downside risk is probably quite low now that they have lost 30 per cent.

While no one can predict when commodity prices will start rising again but certainly if the world economy recovers soon, commodities will probably be a good investment in the medium-term.

Investing through mutual funds rather than directly through individual commodity-based stocks offers a couple of advantages.

The first is diversification so that you are exposed to a wide range of companies in different commodities. This is useful because individual commodities can be highly volatile. Secondly the investor can rely on the expertise of funds which analyse demand and supply conditions in numerous commodity markets to determine which have the greatest potential upside.

So to summarise commodities are quite a promising investment opportunity for the medium term especially if the global economy starts recovering later this year as predicted by many economists. There are several ways of investing in commodities but for the average investor, commodity-based mutual funds are perhaps the safest and most convenient.