With a wide range of products available, finding the commodities investment that is most suitable for you can be a daunting prospect.

Using a collective such as a unit trust, OEIC or investment trust offers a number of advantages – not least the one of familiarity since these products make up the largest proportion of most investors' portfolios. However, there are also many benefits to investing in exchange-traded commodities (ETCs) or exchange-traded funds (ETFs).

An ETF replicates an index, a commodity or basket of assets much like a passive fund, but unlike a tracker, ETFs are traded in the same way as stocks. Without an expensive fund manager at the helm, ETFs offer much lower TERs than mutual funds.

There are two types of ETF – physical and synthetic. Physical ETFs own the securities which make up the index while synthetic ETFs use swaps and other derivatives to replicate the return via a third party. The advantage of the latter is that they offer better returns at a lower cost, but they also carry a counter-party risk.

Ben Seager-Scott, senior research analyst at Bestinvest, says he recommends ETFs if investors want access to instruments that are uncorrelated to other asset classes.

"Investing in a commodity fund is a fairly specialist investment and not for the faint-hearted as prices can be volatile," he said. "One advantage of direct commodity exposure through an ETF is that it generally provides a level of diversification when included with other asset classes."

"With indirect exposure, investors may find the fund, which is invested in equities after all, will tend to have a higher correlation with broad equity markets in the short-term, but should follow the underlying commodity over the longer-term."

Performance of funds vs ETF in 2009



Source: FE Analytics

While commodities funds tend to be more volatile, there are certain circumstances when returns can go through the roof. For example in 2009, against the backdrop of quantitative easing and a rallying gold price, the average gold-focused fund returned 58.27 per cent. This is compared with ETFS Physical Gold – one of the most widely traded commodity ETFs – which returned 13.34 per cent.

However, over the longer-term, gold ETFs have outperformed. ETFS Physical Gold has returned 215 per cent over the last five years while the basket of gold funds has returned just 53.27 per cent in that period.

Performance of funds vs ETF over 5-yrs



Source: FE Analytics

Investing in ETFs is becoming more popular as they provide the diversification of a fund with the flexibility of shares. AWD Chase de Vere’s Patrick Connolly says that while he is happy to recommend the leading commodities funds, he is turning to more direct exposure.

"While we do recommend the JPM Natural Resources and BlackRock Gold & General funds, we don't use them for most of our clients," he commented.

"We invest in commodities through equity stocks and believe that most investors get adequate exposure through broad-based equity funds without the need to invest in specialist commodity funds. We take exactly the same approach in other specialist areas such as technology, financials or healthcare."

Connolly says that investors need to be wary of doubling up their commodities exposure, especially if they already hold more general emerging market funds.

"If an investor holds broad-based funds then investing in specialist-sector funds such as commodities simply increases their exposure to that area and the overall risk in their portfolio."

Connolly also advises that commodities investment is an adventurous play and not suitable for most private investors.

"As with all investments, investors become more interested in commodities after prices have already risen," he said. "This has been most noticeable with the interest we have seen in gold in recent years. The danger is that investors jump in at or near the top of the market, just when that strong performance is coming to an end."