The risks and rewards of commodity funds

By Leonora Walters, 02 December 2010

Record gold prices and inflation worries are drawing investors to commodities. But holding physical assets is not necessarily the best way to invest. An 89 per cent annual return might whet the appetites of those who haven't previously considered a commodity fund.

The best-performing UK open-ended fund (out of 2,819 funds) over the past year was the SF t1ps Smaller Companies Gold Fund. This fund is not a direct gold investor, but rather holds shares in 36 stocks, mostly mining companies. This fund delivered huge returns of 89 per cent over the past year, in contrast to just over 16 per cent for the gold price. It is further evidence in favour of investing in commodity equities via an actively managed fund.

Advantages of equities

Commodity equities are a way of playing emerging markets growth as countries such as India and China develop infrastructure and real estate.

Like the wider market, they are prone to short-term volatility but their performance should be reasonably uncorrelated with other asset classes in your portfolio. An advantage of being equities is that they are driven by movements in equity markets rather than just commodity prices.

Ed Bowie and Steven Poulton, fund managers of the Altus Resource Capital investment trust, believe that a current driver of commodity equities is the fact they have not performed as well as expected from metal price gains. They anticipate that mining equities will continue to perform strongly even if there are no further advances in metals prices.

But it does not mean commodity equities are immune to falls in commodity prices. "The specifics of the individual company will have a significant bearing on their sensitivity to moves in the underlying commodity," says Jason Webster, portfolio manager of VAM Commodities Equity Fund. "When investing, our ideal company is one whose business model is not dependent on commodity prices rising or indeed even maintaining their current levels."

Diversifying via funds

A way to mitigate, although not eliminate commodity price falls, is to invest in a diversified commodity fund, especially as it can be difficult to tell which commodities will fall or outperform.

Commodities are volatile but diversification via an equities fund can smooth this out. A fund of commodity equities provides greater diversification than exposure to the price of a single commodity. The funds that give exposure to a wide range of natural resources spread risk even further.

The various sectors a commodities equity fund has exposure to don't necessarily rise and fall together, while an active manager can move in and out of sectors to take advantage of opportunities and mitigate falls.

The fund manager also has direct contact with the companies and their projects. For example, the managers of the City Natural Resources High Yield Trust stay close to companies they hold and encourage them to pay dividends. Investing directly in a commodity, by contrast, produces no income, interest or dividends, and its price depends solely on supply and demand.

Investment in mining companies allows funds to benefit from mergers and acquisitions. "Merger and acquisition (M&A) activity across the whole mining sector is increasingly becoming a driver of value," explain Ed Bowie and Steven Poulton, managers of the Altus Resource Capital investment trust. "We anticipate further takeovers of a number of its portfolio holdings and that M&A activity elsewhere in the sector will drive up the value of its holdings."

Investors can also benefit from the growth of companies. "The other key advantages of commodity equities are that they allow you to get in on the ground level of what is potentially the next mining giant," says Jason Webster, portfolio manager of VAM Commodities Equity Fund. "For a junior mining company with an economic resource and the funding and management to see it through to production or takeover, the return can be 10, 20 or many more times the original investment. At each stage of its life - from discovery through to production - a company will be re-rated by the market with a commensurate uplift in valuation. The attraction for the investor is that the entry cost in the initial phases is usually very low as there is much still to be proved."

Mr Webster adds that commodity equity funds allow you to invest in sectors where there is no readily accessible futures market, as well as a wide range of service companies. "These include processors, service providers and technology innovators," he explains. "It is important that investors see the commodity equity market as more than just miners and drillers."

Inflation and risks

Investing in equities rather than just the commodity provides a leveraged play on commodities and can magnify returns as in the case of the SF t1ps Smaller Companies Gold fund, although investors should note that this also applies to losses. And there are other risks that you need to consider.

For example, one of the benefits of investing in real assets such as gold is their protection against inflation. "Commodity companies are also natural inflation hedges as the price of their product rises with inflation," says Mr Webster. "A company may be able to insulate itself from inflationary pressures in other markets in addition to enjoying significant foreign exchange gains as local costs are held constant while the price it receives rises."

But metals, natural resources and commodities are all valued based on supply and demand and so can all fall in value. "There will be periods when commodity equities look anything but a good hedge against inflation," says Mr Connolly. "With interest rates remaining at historically low levels, the best approach to counter inflation is to invest in a wide range of asset classes including equities, property and fixed interest."

Mining companies have their own set of risks. "It is worth noting that any returns are reliant on demand for the asset, gold prices and the management of the company, as well as quality of the raw material and cost of extraction," says Sheridan Admans, investment adviser at the Share Centre.

Mines can also be located in unstable parts of the world, making them vulnerable to political interference, wars and other types of disruption.

You are also already likely to have exposure to some of the names held in commodity funds in the core holdings in your portfolio. A UK large-cap equities fund, for example, is very likely to hold some of the many mining stocks listed on the FTSE 100, so a specialist commodities equities fund will raise your exposure to this area.

You should also check what the fund's exposure is to certain commodities, too - for example, some mining or basic resources funds have a heavy bias to gold.

Commodity funds

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