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An Overlooked Benefit of Active Natural Resources Funds

These funds offer an unappreciated layer of diversification versus their ETF counterparts.

Kevin McDevitt, CFA, 04/08/2013

Strong enthusiasm for equity natural resources funds is about as common as rare earth metals these days. That's understandable given their underwhelming performance in recent years. The typical open-end natural resources offering has fallen nearly 1.0% over the past 12 months through April 4, 2013, and the standard natural resources exchange-traded fund has dropped 4.0%. Those showings are downright miserable when compared with the S&P 500 Index's 14.1% gain. During the past three years, natural resources' returns are barely positive while the S&P has gained 12.2% annualized.

The tailwinds that the sector enjoyed in the early 2000s have turned to headwinds in recent years. Global growth has slowed since mid-2011, pushing down commodity prices. Plus, the rampant inflation that many expect as a side effect of global monetary easing hasn't yet materialized. In addition, some wonder whether the commodity supercycle that began around the turn of the century has finally ended. Oil prices peaked in the spring of 2011 and gold hit a record $1,895 per ounce that September. Prices rebounded somewhat last fall, including for industrial metals such as copper, but have since weakened. Natural gas has been one of the few bright spots, as its price has doubled off of its lows plumbed 12 months ago. But natural gas prices are still too low for most oil and gas companies to make much money from extraction.

Nevertheless, investors haven't lost their appetite for equity natural resources funds entirely, but they have shown a clear preference for equity-commodity ETFs rather than their actively managed open-end cousins as of late. During the past 12 months through March, equity natural resources ETFs have collected about $3.0 billion, while their open-end counterparts have seen nearly $2.2 billion in outflows.

An Active Benefit
However, those still interested in natural resources funds--especially investors who are concerned that inflation may one day return--should perhaps give actively managed offerings another look. ETFs certainly offer better alternatives for targeted, specific slivers of the market such as agriculture, timber, etc. But for those looking for one-stop, diversified natural-resources options, actively managed funds are still worth considering. That's because several of these equity funds may be--perhaps somewhat surprisingly to some--purer commodity plays than their equity ETF counterparts, and therefore better diversifiers from an overall portfolio perspective.

This distinction shows most clearly in where these funds get their energy exposure, which tends to claim 50% or more of most diversified portfolios. Since ETFs such as iShares S&P North American Natural Resources IGE and SPDR S&P Global Natural Resources GNR are based on market-cap-weighted indexes, they tend to have significant exposure to the largest energy companies. By and large, these are integrated oil and gas companies like Exxon Mobil XOM and Royal Dutch Shell RDSA. Integrateds account for nearly a third of IGE's portfolio and more than a quarter of GNR's.

While these are excellent companies, they are already well represented in large-cap equity indexes such as the S&P 500 Index or the MSCI EAFE Index and are common to many core mutual fund portfolios, such as those landing in the domestic or foreign large-value and large-blend categories. Furthermore, because these companies operate throughout the energy supply chain--everything from extraction to refining to marketing--their fortunes are not as sensitive to changes in commodity prices as their smaller, more specialized brethren. While this makes them more stable, they don't provide as good of diversification either.

Most open-end natural-resources funds we cover have little exposure to integrated energy companies. In fact, T. Rowe Price New Era PRNEX is the only one with more than 10% of assets in such stocks. Instead, funds such as RS Global Natural Resources RSNRX and Prudential Jennison Natural Resources PGNAX, which has one of the category's highest energy weightings at 74%, focus on smaller exploration and production (E&P) companies such as Concho Resources CXO, as well as equipment and services outfits such as Cameron International CAM.

To be sure, smaller, more commodity-sensitive holdings make these funds more volatile than their ETF counterparts. The Prudential fund has a 10-year standard deviation (a measure of volatility) of nearly 28% versus less than 24% for IGE. But Prudential arguably offers better diversification and better inflation protection should commodity prices re-ignite. For example, the Prudential fund recently had an active share of 95.0% versus the S&P 500 and 88.5% versus IGE.

Conclusion
In the end, what matters most is the contribution an individual holding makes to overall portfolio utility, and these funds can fill a specialized niche for investors. But be forewarned, volatility is part of the deal and such funds will continue to struggle if commodity prices resume their slide. On the other hand, a small slice of one of these funds does offer the potential to offset some of the inflation that many forecasters have been warning about for years. 

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Kevin McDevitt is an Editorial Director with Morningstar.

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