All sorts of commodity funds

How do you put copper or corn in your portfolio? Ten or so years ago, the answer would have been simple: you can't, unless you've a large barn. But an outbreak of innovation in retail financial services has made commodity investment much easier for ordinary folk with limited funds to invest.

If you want to get exposure to commodity markets via a collective fund, you've got two camps to choose from: funds that invest in the shares of companies associated with commodities, and funds that invest in the commodity itself. Within each of those categories, the choice of styles, structures and costs is wide.

The case for equities

Elsewhere in this feature, makes the case for buying the underlying commodity. But there are plenty of good reasons to buy shares in commodity producer, too.

The most obvious is the gearing effect. If the gold price runs up from $1,000 to $1,500 an ounce, that's a 50 per cent gain. But a gold miner whose cost of production is $700 an ounce will see its profit margin rise from $300 an ounce to $800 – a gain of 166 per cent on the same price movement. You only have to look at the earnings performance of many big mining companies to appreciate the powerful effect of commodity price gearing, although bear in mind that it also works in reverse – sharp falls in commodity prices can decimate earnings.

Then there's diversity. "Targeting specific metals, commodities or natural resources is a high-risk strategy, particularly if you invest a significant proportion of your overall portfolio," says Patrick Connolly, head of communications at independent financial adviser AWD Chase de Vere. A commodity equities fund is likely to contain various types of companies, including processors and technology suppliers. In some cases, their share prices may be more resilient.

Shares generate income through dividends, and can enhance value through share buy-backs and mergers, or by finding and developing new reserves. "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," says Jason Webster, portfolio manager of the VAM Commodities Equity Fund. "The attraction for investors is that the entry cost in the initial phases is usually very low as there is still much to be proved."

Equity disadvantages

Just as strong management can build and enrich a company, so lousy management can destroy it, although of course a good fund manager should be alert to this. "The companies you invest in generate all of the money you get, so you have to make sure the company managers are good guardians and invest their profits well or pass it back to shareholders," says Evy Hambro, manager of the BlackRock World Mining Trust. "We are very vigilant as regards this kind of risk."

Even the best managers can hit operational, geological or political problems. Mineral extraction is a risky business. Lonmin, the platinum producer, has grappled with smelter problems for years. Down the decades, there have been many instances of entire mines being expropriated or closed down on spurious legal grounds. Small companies are the most vulnerable to these risks, but even massive companies can trip up – just look at BP. And deposits of oil and metals are finite – so mining and oil companies also have to keep finding new supplies of what they produce to maintain sales.

If you hold a commodity directly and supply is constrained, the price is likely to rise. However, if one company's production is disrupted, its rivals' share prices could benefit as they take its market share.

Most of all, though, shares are shares. Their prices are correlated with many other factors besides commodity prices. If the FTSE 100, which contains many mining and oil stocks, experiences a set-back, as it did during the financial crisis, this can hold back share prices even if commodity producers are making handsome profits. And with resource stocks accounting for a big chunk of key indices, you could find yourself duplicating holdings.

True diversification

Getting exposure to commodities rather than commodity equities will create greater diversification in your portfolio as these have a much lower correlation with equity markets than commodity equities. You are not taking on any company, management or political risk, and assets such as gold are less exposed to swings in business cycles. Investors often turn to real assets such as precious metals in times of economic distress, so commodity prices can rise as equity markets fall.

A tracker fund offering exposure to only one commodity does not offer diversity like a fund; but, if it is a small part of a well-diversified portfolio, a fall in its price won't devastate your overall holdings. You can also buy funds offering exposure to more than one commodity – examples being the ETF Securities Physical PM Basket and ETF Securities All Commodities DJ-UBSCI funds – although these may still not provide as much diversification as an equity fund holding tens or hundreds of shares.

Direct commodity funds are a way to play growing consumption and industrialisation in emerging markets, although you will also be exposed to this benefit in commodity equity funds too.

However, direct commodities funds are only available via passive ETFs and other tracker products, so – unlike commodity shares – they do not offer the possibility of outperformance.

Commodities do not produce income, interest or dividends. Consequently, all your returns must come from price movements, so your timing will need to be good. "Gold, other precious metals and a number of commodities are standing at prices near to their peak," says Mr Connolly. "In all cases there may be further scope on the upside, but it is a big risk for investors trying to time these markets, especially when strong performance has already been achieved."

Commodity funds

There's now a huge number of ways to track individual commodity prices or commodity price indices directly and at low cost using exchange-traded commodities (ETCs). These are similar to ETFs and, as with ETFs, you should make sure that the ETC has UK distributor or reporting status – if they do not, when you sell your fund you may incur income tax on your proceeds, rather than capital gains tax. If you pay tax at the higher rate, that's a big difference.

Also, if you want to hold your ETC in a selfinvested personal pension (Sipp) or individual savings account (Isa), check that you can do this. Not all are eligible for inclusion.

As with ETFs, there is physical replication (buying the underlying asset) and synthetic replication (using futures and derivatives to achieve the same effect).

Physical ownership is largely confined to precious metal ETCs; ETF Securities has funds tracking gold and silver, available in a sterling share class, as well as platinum and palladium. It also offers its ETFS Physical PM Basket which is allocated to gold, silver, platinum and palladium, and could be a good option for mitigating the fall in the price of one commodity. Db X-Trackers also has gold and silver physical funds, and recently iShares launched physical ETCs covering gold, silver, platinum and palladium.

Most other ETCs use futures, enabling their issuers to avoid the costs and hassle associated with storing barrels of oil and bushels of wheat. This has facilitated a big expansion in the number of markets offered – ETF Securities offers funds that follow futures prices covering most types of commodities, including soft and agricultural, industrial and precious metals, and oil and gas – but comes with some major drawbacks.

One is the counterparty risk – if the other side of the futures trade gets into trouble, you could, too. Granted, many of the counterparties are financially strong institutions, but in 2008 a number of ETCs were suspended from trading because the counterparty was insurance company AIG. Since then, providers have taken measures, such as using multiple counterparties or holding collateral equal to or more than the face value of the ETC, so if the counterparty collapses they can draw on this to pay returns to investors. The collateral is often low-risk easily realisable assets such as government bonds or cash. However, not all ETCs are collateralised, and ETCs are not covered by the Financial Services Compensation Scheme.

The other drawback is the risk of underperformance in a strongly rising market. Generally speaking, prices for future delivery are higher than those for immediate delivery (known as 'contango') reflecting the theoretical cost of storing and insuring the asset. As futures approach their expiry date, the ETC provider will generally 'roll' its position in to the next month, by selling the contract close to expiry and buying the next one. The difference in price has to be bridged from the fund's reserves. Over time, this can have a significant impact on returns, as the chart shows.

It tracks Brent crude's spectacular recovery from its 2008 lows, and shows the ETFS Brent ETC (OILB) rebased to the same level. Over two years on, and the difference in performance is vastly greater than tracking error alone would generate.

There will be times when this works in investors' favour; if there's a supply squeeze and prices for immediate delivery are higher than for future delivery (known as a 'backwardation'), then the ETC will outperform the underlying commodity. But, bear in mind that contango is the natural market condition.

You can also get short and leveraged ETFs, but these are much riskier and we would only really recommend them to experienced – and active – traders.

Finally, there's foreign-exchange risk to consider. Commodities are priced in dollars and so are many of the ETCs that track them. If commodity prices rise but the dollar falls, your sterling gains could be trimmed or even eliminated.