How Investing in a Risky Mutual Fund Can Buffer Losses

Jan 30, 2010
Brenna Coleman

It is true that commodity investments can be extremely volatile. At the same time, investing in commodity mutual funds can be a way to minimize the risk of other instruments. They offer a unique form of protection, which can greatly enhance a diverse portfolio.

The Paradox of Commodity Investments

Why is it wise to invest in commodity mutual funds if the commodities market is associated with so many financial dangers? Imagine how much easier it is to lose money on an expected return from cattle futures than from a municipal bond, for example. The cattle futures contract depends on a host of different factors, some predictable, and some not, that could affect the actual price of the product, while the municipal bond is backed by the credit of a local government. Investors must accept plenty of risk with commodities. This risk is healthy for an investment portfolio because it is a completely different kind of risk.

The distinct nature of commodities trading actually buffers the innate risks of an investment portfolio. Commodity mutual funds are not tied up in the stock markets, so they help to balance the risks involved with equity investments. Revolving around actual goods, they are not dependent on currency values, but the actual value of corn, hogs, petroleum, or other goods. In this way, they are an ideal investment to offset the effects of inflation, which can diminish the value of long term bonds and money market investments.

Benefits of Commodity Mutual Funds

Commodity mutual funds in particular are an excellent investment option to add to an already developed portfolio. There is great potential in the commodities markets, not found elsewhere, aside from perhaps the equities market. A fund is led by an experienced manager, who will have both the experience, and the incentive to make wise, well-researched decisions in commodities trading. With commodity funds, the volatile nature of the market is buffered in two ways; by the number of commodities investments, and by the number of investors sharing the risk. Most funds don’t actually purchase products, but rather futures contracts. Futures also help to buffer the risk involved by allowing traders to exchange at pre-determined prices and times.

Investing in Commodities Funds

There are many reasons to add a commodities fund to an investment portfolio. There are reasons to be wary as well. When the price of goods is on the rise, a fund will probably show reasonable returns, but if prices have been high for some time, a mutual fund investment could lose value. This is an investment that requires some research. Make sure prices are likely to rise, not fall, before stepping into the commodities market. If there has been a rush to commodities investments, be careful not to step in too late.

While a commodity mutual fund can help balance other investment losses due to inflation, this favorable aspect dissolves when inflation is not an issue. Right now, inflation is a huge concern as money has been flooded into the economy and the price of goods has steadily risen. Many investors have turned to commodity funds and commodity futures funds, which depend on the value of natural resources, metals, livestock, and crops.

When looking for the right commodity fund, evaluate performance and the likeliness of continued positive or negative earnings. Look at how the actual fund is diversified (many funds are heavy in favor of energy futures), and factor in fund fees and commission. There are not as many commodity mutual funds to choose from as other types of mutual funds, but with patience and investigation, the perfect fund to fit an individual investor’s needs can bring that extra edge to a solid portfolio.

Sources:

Benz, Christine. “Guide to Mutual Funds: 5-Star Strategies for Success.” (Morningstar Inc., 2005).

Levinson, Marc. “The Economist: Guide to Financial Markets.” Third Edition (Bloomberg Press, 2003).

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