Investors have numerous resources when it comes to buying and selling stocks or bonds, but the options for gaining exposure to commodities are more limited.
While institutional and sophisticated investors may be able to trade in the futures market for commodities, everyday investors must rely on alternative sources like mutual funds and ETFs.
While both types of investment vehicles offer commodities exposure to investors, one is a superior choice to the other. On the surface, both offer investors a way of investing in commodities but dig a little deeper and you’ll discover some fundamental flaws in the mutual fund industry that make ETFs a better way to go.
The Downside of Commodities Mutual Funds
For decades, the investment world has been largely dominated by the mutual fund industry. It’s the standard go-to in any retirement account like a 401(k) or IRA, and usually one of the first investments you make when starting a portfolio. The relative ease of opening an account and funding it with small monthly payments make mutual funds an attractive choice. But when it comes to investing in commodities, mutual funds haven’t engaged investors very well.
Mutual funds come with professional management that acts to trade futures contracts and make adjustments in the portfolio as needed. But this management comes with a price that’s reflected in its expense ratio. These ratios for commodities funds average over 1% and can even top 2%. That’s a significant reduction in annual returns and can result in a large amount of money wasted when taking a long-term viewpoint.
In a broader sense, investors have been eschewing mutual funds in favor of ETFs over the past several years. In 2017, equity mutual funds registered outflows of more than $207 billion, while $220 billion poured into ETFs. The massive departure from mutual funds mainly stems from the lackluster performance and exorbitant fees and commodities mutual funds are no different.
Mutual funds are also not ideal investment vehicles for commodities investing. Unlike stocks, which are meant to be held long-term, sometimes more than a decade, commodities are a much shorter-term type of investment. They don’t appreciate like a business does and, typically, perform at their best when stocks are underperforming – something that doesn’t happen for an extended period of time.
An example of a broad commodities mutual fund is the Invesco Balanced-Risk Commodity Strategy Fund Class C (BRCCX), which invests across all commodity types but comes with a hefty 2.33% net expense ratio.
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Why Choose an ETF for Commodities
Exchange-traded funds (ETFs) have several advantages over mutual funds when it comes to commodities. Advantages like increased liquidity, ease of investing, lower expense ratios and more diverse options give ETFs an edge over traditional mutual funds.
ETFs trade much like stocks do and are highly liquid investments. They can be bought and sold at a moments notice anytime during the trading day making it easy for investors to buy or sell commodities ETFs when opportunities arise. Investors can initiate positions in commodities ETFs when it’s appropriate and sell quickly when they rotate out of favor.
As a passively managed vehicle, ETFs come with fairly low expense ratios compared to commodities mutual funds. While some ETFs charge as high as 1%, most fall under that figure. That means that investors are able to pocket a higher percentage of their total annual returns in an ETF compared to what they would get in a mutual fund.
The broad range of ETFs gives investors the ability to customize their investment strategy as well. Investors can invest in a broad commodities fund or be selective and invest only in agricultural or mineral funds. There are numerous options for investors to choose from.
Investors also get the most out of their money when it comes to ETFs compared to mutual funds. Expense ratios tend to be smaller due to limited professional management, which means that even if a particular mutual fund matched the gains made in an equivalent ETF, investors will achieve a higher return on the ETF.
One of the largest commodity-based ETFs is the Invesco DB Commodity Index Tracking Fund (DBC), which holds a broad portfolio of commodities and comes with a relatively low 0.85% expense ratio.
Click here to read about how Investors Should Avoid Treating Commodity-Based ETFs As Actual Commodities.
A Note About Futures and Leverage
Unless you’re dealing with the physical delivery of a commodity, futures are how investment transactions take place. Contract prices for future maturation dates fluctuate as the underlying commodity changes in value – and more so when leverage is applied.
Leverage is a common tool in the futures market and many mutual funds along with ETFs offer leveraged fund options for investors. Leverage of two or even three times the benchmark index can be found as well as inverse funds that profit when commodity values drop. While the temptation of higher returns is a powerful motivator, investors should think carefully before buying a leveraged commodity ETF.
Gains may be amplified, but losses are equally amplified making it far riskier than the average commodity ETF.
The Bottom Line
Investing in commodities is a great way to diversify a portfolio outside of stocks and bonds. While both mutual funds and ETFs give investors exposure to commodities, ETFs are generally the better choice. When considering commodity investments, ETFs offer the most benefits.
Be sure to check our News section to remain updated on the latest happenings in the commodity space.