Commodity Index Fund
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A commodity index fund may be a good investment opportunity for prudent investors. Commodities are usually raw materials, such as metals, minerals, and fuels, or agricultural products, such as grains, cotton, coffee, and cocoa. Livestock such as cattle and hogs are also types of commodities. These products are generic in nature which means that it doesn't make much difference which producer mines, drills, grows, or raises them. For the most part, oil is oil and soybeans are soybeans, though the quality may be graded. Some people trade in commodity futures, but these are generally considered to be risky and speculative investments. Instead of buying and selling the actual commodities, the traders buy and sell futures contracts which are standard contractual agreements set by exchanges such as the Chicago Board of Trade. These contracts specify a set quantity and grade for particular commodities. The traders rarely possess or take delivery of the products, but offset purchases and sales with other purchases and sales before the delivery date. The exchange clearinghouse handles the trading accounts. Money is made when a trader sells a contract for more than its purchase price and money is lost when the trader is forced to sell the contract, before the delivery date, for less than its purchase price. Commodities are usually considered to be a volatile investment. The rewards may be great, but so are the risks. Investors may prefer the lower volatility of a commodity index fund instead of taking higher risks with futures contracts.
An index fund, of whatever type (stocks, bonds, commodities), usually provides more safety than ownership of individual stocks, bonds, or futures contracts. This is because an index fund is a collection of individual investment products. For example, the well-known Standard and Poor (S&P) index consists of 500 large cap common stocks. A committee decides which stocks to include based on specific rules. Though not a fund itself, several companies offer funds that copy the S&P. Additionally, many mutual and index funds compare their periodic returns to that of the S&P to provide a benchmark for current and potential investors. A commodity index fund would include a number of commodities. This way, instead of investing in futures contracts, an investor would own small bits of several commodities. The fund's managers may need to follow pre-set rules regarding the fund's makeup. For example, a particular fund may be allowed to consist of only a certain percentage of oil and a lesser percentage of gold in addition to other commodities. Some funds may specialize in certain commodities, such as minerals or fuels. Regardless of the pre-set rules, the fund's managers must adjust the ownership of commodities to stay within those rules.
An actively managed commodity index fund provides the managers with more flexibility. Though certain guidelines may prevail, actively managed funds can be adjusted to meet specific market conditions and to take advantage of identifiable market trends. A prospective investor needs to do her homework when evaluating investment opportunities. This is true, even for investors of the more traditional stocks and bonds. But it's especially true for commodity investors. In fact, financial experts recommend that commodities make up only a small percentage of an already well-diversified portfolio. Diversification enables investors to reduce risk to the overall value of the portfolio by investing in a variety of investment products. A good, solid mix of mutual funds that includes both stocks and bonds is the foundation for a well-designed portfolio. The addition of a commodity index fund can add additional value and, perhaps, offset losses in stocks and bonds due to inflation or certain crises. Some people believe this advice from King Solomon can apply to investment portfolios: "Cast thy bread upon the waters: for thou shalt find it after many days. Give a portion to seven, and also to eight; for thou knowest not what evil shall be upon the earth" (Ecclesiastes 11:1-2). Diversification is an important principle for wise investing.
Historically, the value of commodities goes up when the value of stocks and bonds go down, but the commodities go down in value when stocks are booming. A simplistic reason for this historic trend has to do with interest rates and inflation. Basically, inflation is associated with higher interest rates. These higher rates mean that corporations must pay higher costs to borrow money. This additional borrowing expense lowers a stock's earnings per share and the value of the company's stock decreases. Conversely, in inflationary times, the supply of commodities usually is less than the demand. The economic supply/demand seesaw means that commodities are more valuable when the demand exceeds supply. A commodity index fund can be an important, and valuable, asset during inflationary periods.
Again, it's important for an investor to do her homework before putting money into a commodity index fund. In addition to knowing whether the particular fund follows pre-set rules or is actively managed, the investor should look at the fee structure. A wise investor will be sure that the fund's results justify the fees. She should also look at each fund's historic performance record. Though past results do not guarantee future performance, it's still advisable to choose a commodity index fund with a strong track record over one that's mediocre. By educating oneself on various investments and making sure that one's portfolio is already diversified with a good mix of stock and bonds, the investor may find that adding a small percentage of commodities is a good hedge against inflation.
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