The commodity boom has arrived. 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 new demand as the world builds green infrastructure and more electric cars. Investments in fossil fuels are declining, but renewable sources are not yet ready to take their place.

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

“This domino effect is doing the rounds of the entire commodities landscape right now,” says Jason Bloom, head of fixed income and alternative ETF product strategy at Invesco.

If you don’t own commodities due to their lagging performance over the past decade, it might be time to reconsider. “Commodity 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 are prepared to trade commodity futures, mutual funds and exchange-traded funds are the most convenient way to invest in this asset class. Year-to-date, US commodity funds have generated an average return of 17%, while stocks and bonds are down. Commodity ETFs alone have seen nearly $9 billion in net asset inflows this year, according to FactSet.

Choosing a commodity fund can be difficult. Some bet on a particular commodity, while diversified portfolios could dampen volatility and reduce risk. But there is a wide variation in what they hold and in how much. Investors must choose carefully.

Largest commodity index ETF, $7.5 billion

Invesco Optimum Yield Diversified Commodity Strategy No K-1
(ticker: PDBC), holds more than half of its holdings in energy futures such as oil and natural gas, with the rest of its weighting split between metals and agricultural commodities. It worked well over the past year as energy prices soared. The fund has gained 55% in 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, investment adviser 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 does not necessarily offer such advantages, she notes.

This is why actively managed commodity funds often reduce their exposure to energy and look for opportunities elsewhere. The $3.5 billion

First Trust Global Tactical Commodities Strategy
ETF (FTGC) has less than a third of its assets in energy and holds nickel and platinum futures. The $8.2 billion

Pimco CommodityRealReturn Strategy
(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 US ETF to do so. “Bitcoin, with its fixed supply, competes as a next-generation store of value like gold,” says Jeremy Schwartz, global chief investment officer at WisdomTree.

Mutual funds often charge higher fees than ETFs or have high sales charges. The Pimco fund, for example, has an expense ratio of 1.44% and an entry fee of 5.5% for investments below $50,000. ETF Invesco only charges 0.68%, while ETF First Trust and WisdomTree charge 0.95% and 0.55% respectively and charge no fees.

When buying commodity funds, investors should look for those that maximize “rolling yield” – the cost or benefit when expiring futures contracts are replaced by longer dated contracts. If a commodity is in contango, meaning the futures prices are above the spot price, rolling the contracts would cost money. Conversely, if the commodity is in backwardation, meaning the spot price is higher than the futures, it would generate positive returns.

While some funds automatically roll over their contracts to the first month on a fixed date, others aim to minimize costs and maximize returns by contracting with the lightest contango or largest offset at the best possible time. This means that these funds can hold contracts further down the curve than futures, which tend to be less volatile but deviate further from spot prices.

Over the past decade, thanks to falling spot prices and the constant contango of many commodities, contract turnover has cost the Bloomberg Commodities Index more than 7% annually, Schwartz says.

Today, spot prices are rising, contract rollovers are generating returns, and even the collateral used for futures positions – typically Treasury bills or short-term commercial paper – could start to generate higher returns. high as the Federal Reserve raises interest rates. “We are clearly seeing the reversal of a very long trend of poor commodity performance,” duQuesnay said.

Yet commodities can become very volatile, even with their long-term tailwinds. “Commodities are always vulnerable to economic and demand shocks,” Bloom says. “If you get another variant of Covid-19 that brings the economy to a halt again, or if the Fed overdoes the rate hikes and drags the economy into a recession, that would be very negative for commodity prices.”

Investors must be prepared to overcome obstacles.

Write to Evie Liu at evie.liu@barrons.com