The Commodities Boom Is Here. How to Invest With Funds.

The global effort to decarbonize the economy could be another long-term tailwind. Industrial metals like lithium and cobalt are seeing newfound demand as the world builds out green infrastructures and more electric cars. Investments in fossil fuels are decreasing, but renewable sources aren’t ready to take their place just yet.

Energy prices will likely remain high, while supplies of industrial metals and agricultural products—both of which require large amounts of energy to produce—will likely shrink.

“This domino effect is circling through the entire commodity landscape right now,” says Jason Bloom, head of fixed income and alternatives ETF product strategy at Invesco.

If you don’t own any commodities due to their laggard performance over the past decade, it might be time to reconsider. “Commodities cycles tend to be longer in nature,” says Ed Egilinsky, head of alternative investments at Direxion. “We are still in the early innings of a supercycle.”

Unless you’re prepared to trade commodity futures, mutual funds and exchange-traded funds are the most convenient way to invest in the asset class. Year to date, U.S. commodity funds have returned an average of 17%, while stocks and bonds are both falling. Commodity ETFs alone have seen nearly $9 billion in net asset inflows this year, according to FactSet.

It can be challenging to pick a commodity fund. Some bet on one particular commodity, while diversified portfolios could mitigate volatility and reduce risks. But there is wide variance in what and how much they hold. Investors should choose carefully.

The largest index-tracking commodity ETF, the $7.5 billion Invesco Optimum Yield Diversified Commodity Strategy No K-1 (ticker: PDBC), has more than half its holdings in energy futures like oil and natural gas, with the rest of its weighting split between metals and agricultural products. That’s worked well in the past year as energy prices soared. The fund has gained 55% over the past 12 months, beating 90% of its peers, according to Morningstar.

But some investors might want a more-diversified basket instead of a proxy for energy, says Blair duQuesnay, an investment advisor at Ritholtz Wealth Management. Commodities are often used to diversify a portfolio due to their low correlation with stocks and bonds. A fund heavily weighted in energy doesn’t necessarily offer such benefits, she notes.

That’s why actively managed commodity funds often dial back their energy exposure and seek opportunities elsewhere. The $3.5 billion First Trust Global Tactical Commodity Strategy ETF (FTGC) has less than less than one third of its assets in energy and owns nickel and platinum futures. The $8.2 billion Pimco CommodityRealReturn Strategy fund (PCRAX) invests in carbon credits created by cap-and-trade programs in California and Europe.

The $300 million WisdomTree Enhanced Commodity Strategy ETF (GCC) even added a 3% position in Bitcoin futures last year, the first U.S. ETF to ever do so. “Bitcoin, with its fixed supply, is competing as the new generation store of value as gold,” says Jeremy Schwartz, global chief investment officer at WisdomTree.

Mutual funds often charge higher fees than ETFs, or have hefty sales charges. The Pimco fund, for example, has an expense ratio of 1.44% and a 5.5% front-end load for investments under $50,000. The Invesco ETF only charges 0.68%, while the First Trust and WisdomTree ETF charge 0.95% and 0.55%, respectively, and charge no loads.

When shopping for commodity funds, investors should look for those that optimize the “roll yield”—the cost or benefit when the expiring futures contracts are rolled to longer-dated ones. If a commodity is in contango, meaning futures prices are higher than the spot price, rolling the contracts would cost money. Conversely, if the commodity is in backwardation, meaning the spot price is higher than futures, doing so would generate positive yields.

While some funds automatically roll their contracts to the front month on a fixed date, others aim to minimize costs and maximize yields by rolling into contracts with the mildest contango or the steepest backwardation at the best possible time. That means these funds can hold contracts further out on the futures curve, which tend to be less volatile but diverge more from the spot prices.

Over the past decade, thanks to the falling spot prices and consistent contango in many commodities, rolling the contracts cost the Bloomberg Commodities Index more than 7% a year, says Schwartz.

Now, spot prices are rising, contract rolling is generating yields, and even the collateral used for futures positions—usually Treasury bills or short-duration commercial paper—could start to generate higher yields as the Federal Reserve raises interest rates. “We are clearly seeing the reversal of a very long trend of poor performance in commodities,” duQuesnay says.

Still, commodities can become highly volatile, even with their long-term tailwinds. “Commodities are still vulnerable to economic and demand shock,” says Bloom. “If you get another Covid-19 variant that shuts down the economy again, or if the Fed overkills in rate hikes and drives the economy into a recession, it would be very negative for commodity prices.”

Investors should be prepared to ride out the bumps.

Write to Evie Liu at [email protected]