Commodity Fund Fundamentals

2010 was a bumper year for commodities. Cotton was up by 96%, coffee by 62% and copper by 30%. In fact I am struggling to think of a commodity that didn't have a stellar year.

However, the same cannot be said for all commodity funds. Why is this?

The main reason is that not all commodity funds invest in the same way. The generic label "commodity fund" actually captures several distinct types of investment. It is therefore important that you understand how your chosen commodity fund works before taking the plunge.

To help you do so, I have listed the 3 main types of commodity fund below.

True Commodity Funds - These funds actually have a direct holding in the relevant commodities. A common example is a gold fund. The main reasons that gold is more common as a direct holding are:

a) It doesn't deteriorate over time
b) You require a lot less space to store gold which costs USD1,400 an ounce than you do oil at USD100 a barrel.

Commodity Funds that Hold Futures Contracts - A much more common strategy is for the fund to hold derivative contracts based on the underlying commodity price. The reason for this is that most investors have no desire to take delivery of hogs, corn, oil or any other commodity, they simply want to profit from price changes.

This type of fund however exposes you to the risk of "contango". Normally the price to buy a commodity today (spot price) is higher than the price to buy it in the future. However, in times of high demand or uncertainty the future price can be higher than today's spot price. When this happens there is a risk that when the futures contract matures, it will do so at a price lower than the original purchase price, thus creating a loss.

A good example of this was back in 2008 when funds holding oil futures contracts managed to lose money despite the price of oil surging to USD150 a barrel.

Natural Resource Funds - These are funds that invest in shares of companies that are engaged in commodity related fields, such as energy, mining, oil drilling and agricultural businesses.

While they hold neither actual commodities nor commodity futures, they still provide some exposure to the underlying commodities markets by proxy.

The downside to natural resource funds as opposed to the other 2 is that, while actual commodities and commodity futures historically have a low correlation to the equity markets that probably make up the bulk of your current portfolio, natural resource funds will be more correlated as at the end of the day they are still investing in stocks.