What Is a Commodity Pool?

A commodity pool is a private investment structure that combines investor contributions to trade the futures and commodities markets. The commodity pool, or fund, is used as a single entity to gain leverage in trading, in the hopes of maximizing profit potential. The title "commodity pool" is a legal term as set forth by the National Futures Association (NFA). Commodity pools are also called "managed futures funds."

Key Takeaways

  • A commodity pool is a private investment structure that combines investor contributions to trade futures and options in commodities.
  • The commodity pool, or fund, is used as a single entity to gain leverage in trading, in the hopes of maximizing profit potential.
  • The risk of investing in commodity pools is limited to the amount of an investor's financial contribution to the fund.

How a Commodity Pool Works

Commodity pools are funds that contain a pool of capital from many investors in which the contributed money is combined and invested by the commodity pool investment management team. Commodity pool investments typically use leverage, which is borrowed money from a broker designed to magnify the returns on the investment. Commodity pools are similar to mutual funds, which are funds of pooled money that invest in a basket of securities, including stocks.

Many hedge funds–private pools of activity managed capital–are commodity pools. However, instead of investing in stocks, commodity pools invest in a basket of commodity futures contracts and options. A futures contract is an agreement to buy or sell a commodity or security at a preset price, quantity, and time in the future. Futures contracts have standardized amounts and settlement dates and are traded on a futures exchange

Options contracts are similar to futures and give the holder the right to buy or sell the underlying asset at a preset price and date. However, options are more flexible than futures since they have more expiration dates available, and the contract sizes can be customized. Both futures and options contracts are considered derivatives since the contracts derive their value from an underlying commodity or security. A commodity pool's futures and options contracts can include investments in gold, silver, corn, crude oil, and wheat.

Commodity Pool Operators

A principal or partner in the firm or fund would be in charge of the financial interests within the commodity pool. The commodity pool operator receives the funds to use in the operation of a commodity pool, syndicate, investment trust, or another similar fund, specifically for trading commodities. The commodity pool operator would often solicit investors to bring in new funds or capital for the commodity pool.

Commodity Pool Regulators

Commodity pools in the United States are regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association, rather than by the Securities and Exchange Commission (SEC), which regulates other market activity.

Hedge funds that are commodity pools must be registered with the Commodity Futures Trading Commission as commodity pools and Commodity Trading Advisors (CTAs). CTAs are similar to financial advisors in that they are registered advisors, but instead of providing stock advice, CTAs advise investors on commodity investing.

Commodity Pool ETFs

A simplified method for retail investors to obtain market access is through exchange traded funds (ETFs). These funds are similar to mutual funds but tend to have much lower costs. Commodity ETFs can be a type of commodity pool where investors pool financial resources to gain access to commodity futures markets. One reason for the explosive growth of the ETF industry is that they have dramatically expanded the way that investors can gain access to commodities.

However, not all commodity ETFs invest in commodity futures. Some commodity-based ETFs hold the stocks of commodity-producing companies such as gold mining and oil drilling companies. Other commodity ETFs buy and hold the physical commodity itself and store the investment in a vault. A gold or silver ETF, for example, might hold the physical commodity. Before investing in a commodity-based ETF, investors should research what type of holdings are in the fund.

Benefits of a Commodity Pool

Commodity pools provide a number of benefits to investors in lieu of investing in the individual commodities that are held within the fund.

Professional Management

Commodity pools benefit investors since they gain access to trades that would not be possible for an individual investor. Investing in futures and options contracts can be quite complex, and by deferring to an expert that's licensed to trade derivatives, investors save money from the potential costly mistakes of going it alone when investing in commodity futures.

Leverage

Investors gain leverage in trading, meaning they join a pool with a number of different investors, which increases their purchasing power. Investors gain more leverage and diversification, for example, by trading a $1million pooled account as opposed to a $10,000 individual account had the investor gone it alone.

Defined Risk

However, the risk of investing in commodity pools is limited to the amount of the investor's financial contribution to the commodity pool. Futures contracts often use borrowed funds from a broker, but no matter how big the fund's losses are due to that leverage, the investor is at risk for only the amount they contributed. The limited risk is due, in part, to the structure of commodity pools in that they're typically established as limited partnerships.

As a result, investors can control the amount of money they want to allocate to a commodity pool, depending on their risk tolerance, age, financial standing, and time horizon for investing. However, investors who are unfamiliar with commodities, futures, and options should seek help from an investment advisor to determine whether a commodity pool is the right investment for them.