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Balanced Exposure to the Natural-Resources Sector

While this natural-resources ETF isn't for the faint of heart, it can offer good diversification benefits.

Alex Bryan, 12/16/2016

An investment in natural-resources commodities can offer good diversification benefits and a partial hedge against inflation (1). Because it is difficult to store most commodities (aside from precious metals), most commodity-oriented funds either invest in commodity futures or in the stock of companies whose businesses are tied to commodity prices. There is a trade-off between the two approaches. Commodity futures are more highly (though not perfectly) correlated with commodity prices than natural-resources stocks. But they introduce roll-yield risk, where some slippage could occur if an expiring contract has a lower price than the contract replacing it. And funds that invest in commodity futures tend to be more expensive and less tax-efficient than those that invest in natural-resources stocks. SPDR S&P Global Natural Resources ETF GNR is one of the better options in the latter group.

This index fund invests in the world's 90 largest stocks in the energy, agriculture, and metals and mining sectors. In order to better diversify the portfolio, the fund assigns equal weightings to each of the three sectors. This prevents it from tilting heavily toward energy stocks, which would receive larger representation in a market-cap-weighted portfolio. Its holdings' revenue and performance are tied to the prices of the commodities that they or their customers sell. Because these commodities are cost drivers for companies in many other industries, their prices have relatively low correlation with the broad stock market. However, the fund is more highly correlated with the market than funds that invest in commodity futures.

Natural-resources commodity prices tend to be volatile largely because suppliers cannot quickly adjust production to match changes in demand. Fixed costs can amplify the effect of fluctuating commodity prices on the profitability of the fund's holdings. This sensitivity is great when demand is strengthening, but it also introduces considerable risk. Investors in this fund are not just betting on high commodity prices but also that its holdings will be able to hold costs down. Therefore, the fund's performance will not directly correlate with natural-resources commodity prices. In fact, many of its holdings hedge their exposure to short-term commodity price movements.

As a result of its balanced subsector portfolio, the fund usually has greater exposure to metals and mining stocks than the natural resources Morningstar Category average and less exposure to energy stocks. It also has greater exposure to foreign stocks, which account for nearly two thirds of the portfolio. The fund's overweighting in metals and mining stocks detracted from performance during the trailing five years through November 2016. During that time, the fund lagged the category average by 16 basis points annualized, with comparable volatility.

Fundamental View
Mining is a tough business. Miners often start expanding during commodities rallies, but it can take years to bring additional capacity on line, by which time commodity prices may have fallen. These firms cannot quickly adjust production as prices fluctuate. Consequently, they can expose investors to significant losses as commodity prices slide. But they may offer attractive returns when commodity prices rise.

The fund's holdings in the metals and mining industry, such as Rio Tinto RIO and Freeport-McMoRan FCX, face a challenging environment. Industrial-metals prices have fallen over the past five years in the face of slowing fixed asset investment growth in China, which is one of the world's largest markets for industrial metals, such as iron and copper. Morningstar equity analysts believe that Chinese demand for industrial metals will continue to weaken over the next few years, potentially putting downward pressure on prices. The steel industry has also been plagued by overcapacity and weak demand, which may continue to weigh on steel prices in the near term.

Oil and U.S. natural gas prices have increased from depressed levels over the trailing 12 months through November 2016. Production growth in the United States, resulting from hydraulic fracturing, had previously flooded the market with supply, depressing prices. In response to weak prices, producers have reduced supply growth, while demand has strengthened. However, if prices increase, U.S. production could ramp up, limiting long-term price growth.

Because it is expensive to transport natural gas across markets, U.S. natural gas prices are significantly lower ($3.32/MMBtu as of November) than the import prices in Europe or Japan ($4.91 and $7.15/MMBtu, respectively). Over the longer term, the disparity between natural gas prices in these markets should narrow as new shipping facilities come on line. Natural gas is a significant cost driver for the fund's nitrogen fertilizer producers, including Agrium AGU and Potash Corporation of Saskatchewan POT. Consequently, these holdings may partially hedge the fund's exposure to natural gas prices.

Alex Bryan is an ETF analyst with Morningstar.

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