Commodity Mutual Funds Part 1: How They Work

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

Mutual Funds Meet Commodities

Chapter 14 is a big one, so I am splitting it into three posts. This first part covers the basics: what commodity mutual funds (CMFs) are, how they differ from ETFs and hedge funds, how they are structured, and what risks come with them.

CMFs are exactly what they sound like: mutual funds that invest in commodity-related assets. But here is the important thing – most of them do not actually buy commodities directly. Instead, they invest in stocks of companies that produce, mine, or process commodities. The average CMF in the CRSP database held about 81.4% of its assets in equities.

So when you buy a gold mutual fund, you are probably buying shares of gold mining companies, not gold itself. When you buy an energy mutual fund, you are buying oil and gas company stocks. This is a fundamental difference from commodity ETFs, many of which hold physical commodities or futures contracts.

How CMFs Differ from Other Investments

The chapter does a good job distinguishing CMFs from the other commodity investment vehicles covered in the book.

CMFs vs. ETFs: Mutual fund shares are bought and sold at the end-of-day net asset value (NAV), not on an exchange throughout the day. ETF prices fluctuate second by second based on supply and demand. Mutual funds are generally more transparent about their holdings than hedge funds but less transparent than ETFs, which disclose holdings more frequently for intraday valuation.

CMFs vs. Managed Futures: Managed futures funds (covered in Chapter 12) invest in futures contracts and derivatives. They go long and short. Most CMFs invest in stocks and bonds. Managed futures funds are regulated by the CFTC, while CMFs are regulated by the SEC.

CMFs vs. Hedge Funds: Mutual funds are publicly offered, regulated by the SEC, and must offer daily liquidity to investors. Hedge funds are secretive about their strategies, do not provide NAV as frequently, and often charge performance-based fees. Most CMFs do not charge carried interest – their management fees are based on assets under management regardless of how the fund performs.

The Biggest CMFs

The largest commodity mutual fund as of June 2016 was the Vanguard Specialized Energy Fund, with over $10 billion in assets. PIMCO’s Commodity Real Return Strategy Fund came in second at $6.5 billion. The top 20 list included a mix of:

• Energy-focused funds like Vanguard Energy, Fidelity Select Energy
• Precious metals funds like Vanguard Gold & Precious Metals, Fidelity Select American Gold
• Broad commodity funds like Credit Suisse Commodity Return Strategy, T. Rowe Price Real Assets
• MLP (Master Limited Partnership) funds like SteelPath MLP Alpha, SteelPath MLP Income

The total database the authors worked with contained 207 CMFs between 1996 and 2016. The number of funds grew from 56 in 1996 to a peak of about 207 by 2016, with the fastest growth happening between 2007 and 2014.

How Mutual Funds Work (Briefly)

For readers who might not be familiar with mutual fund basics, here is a quick rundown of the relevant details.

Mutual funds are open-end investment companies. There is no fixed number of shares. When you invest money, new shares are created. When you redeem, shares are retired. The price you pay (or receive) is the NAV, calculated once per day at market close.

NAV is the total value of the fund’s assets minus any liabilities, divided by the number of shares outstanding. Unlike ETFs, supply and demand does not determine the price. The underlying asset values do.

Most CMFs are actively managed, meaning a portfolio manager picks securities with the goal of outperforming some benchmark. Passive management (index tracking) exists too, but it is less common among CMFs. Active management means higher fees, which is a theme that comes up again later in Chapter 14.

Returns from mutual funds come in two forms: unrealized capital gains (the value of your shares going up or down) and distributions (dividends and proceeds from selling assets within the fund). Importantly, mutual funds must pass through realized capital gains to investors, which can create tax headaches even if you did not sell your shares.

Why Invest in CMFs?

Two main reasons, according to the chapter.

Diversification. CMFs provide exposure to commodity markets, which historically have low correlation with stocks and bonds. Adding commodity exposure to a traditional portfolio can reduce overall risk. That is the standard argument, and it holds up in the data (more on that in Part 2).

Active management potential. Because CMFs are actively managed, there is at least the possibility of earning returns above a benchmark if the fund manager has genuine skill at picking underpriced securities. Whether managers actually deliver on this promise is another question we will address in Parts 2 and 3.

The Risks

The chapter is straightforward about the downsides.

Underperformance is the primary risk. CMFs can lose money outright, or they can deliver returns that do not adequately compensate for the risks, especially after fees. As we will see in the performance section, risk-adjusted returns for the average CMF are not great.

Liquidity risk is real. During market stress, when lots of investors want to redeem at the same time, the fund may struggle to sell its holdings in an orderly way. The costs of forced selling get spread across all investors, not just the ones redeeming. This happened during the 2008 financial crisis when many funds faced large redemption requests.

Tax treatment can be unfavorable. Because mutual funds pass through realized capital gains, you might owe taxes even in years when you did not sell any shares and the fund’s NAV actually went down. This can be an unpleasant surprise.

The Database

The analysis in Chapter 14 uses the CRSP (Center for Research in Security Prices) Mutual Fund Database from the University of Chicago. One nice feature: it is survivorship-bias-free, meaning it keeps data for funds that closed down. This matters because databases that only include surviving funds systematically overstate average performance.

There is one limitation, though. Elton, Gruber, and Blake (2001) found that the CRSP database may miss funds with NAVs below $15 million. So the analysis only includes funds above that threshold.

CMFs were identified using Lipper/CRSP classification codes for commodity categories, or fund names containing “commodity” or specific commodity names like “gold.” After filtering out ETFs and managed futures funds, the authors ended up with 207 CMFs over the 1996-2016 period.

Gold CMFs and energy CMFs were the two dominant subcategories. In 2016, gold CMFs accounted for about 38% of total CMF assets, while energy CMFs made up about 14%.

Coming Up Next

In the next post, I will cover the performance data: how CMFs actually did between 1996 and 2016, their correlations with commodity prices, and whether fund managers generated meaningful alpha. Spoiler: the results are mixed, and the time period matters a lot.

Previous: Commodity ETFs: The Easy Way to Invest in Raw Materials

Next: Commodity Mutual Funds Part 2: Performance and Returns