Balanced Exposure to the Natural-Resources Sector

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.

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

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

Crop prices can have a significant impact on demand for yield-enhancing seeds, chemicals, and equipment in the short term because farmers' incomes are closely tied to them. Over the longer term, growth in global population and rising incomes in developing markets will require agricultural output to increase significantly, according to the Food and Agricultural Organization. Because the amount of arable land is relatively fixed, these long-term trends likely will increase demand for yield-enhancing products. This should benefit the fund's holdings in the agricultural industry, though competition may erode some of their profits. Most of the portfolio is invested in stocks that do not enjoy durable competitive advantages, based on Morningstar equity analysts' assessments.

Portfolio Construction The fund employs full replication to track the S&P Global Natural Resources Index. This index includes the world's 90 largest stocks in the agriculture, energy, and metals and mining sectors. Within each sector, S&P selects the 30 largest stocks and weights them by market capitalization. In order to better diversify the portfolio, S&P assigns equal weightings to each of these three subsectors. It also caps each sector's U.S. and emerging-markets exposure at 40% and 15%, respectively, and limits individual holdings to 5% of the total portfolio. In order to qualify for inclusion in the index, each holding must trade on a developed-markets exchange and meet minimum liquidity requirements. The index is reconstituted annually in August and rebalanced quarterly. Top country weightings belong to the U.S., United Kingdom, and Canada. However, the fund's holdings have global operations and are exposed to global commodity markets.

Fees The fund charges a reasonable 0.40% expense ratio, which is comparable to its closest peers and lower than the category average. However, it outpaced its benchmark by 8 basis points annually over the trailing three years through November 2016. State Street engages in share lending, the practice of lending out the fund's underlying holdings in exchange for a fee. It passes through 85% of the proceeds to investors, which partially offsets the fund's expenses.

Alternatives VanEck Vectors Natural Resources ETF HAP (0.50% expense ratio) is one of the closest substitutes. HAP tracks companies that generate more than 50% of their revenue from the production of commodities. Its portfolio rests on a broader base of more than 300 securities across six hard-asset sectors.

FlexShares Morningstar Global Upstream Natural Resources ETF GUNR (0.46% expense ratio) targets companies with operations at the top of the supply chain in natural-resources industries. (This fund tracks a Morningstar index, and Morningstar receives a fee based on assets invested in it.) While GUNR applies market-cap weighting within each sector, it assigns 30% weightings to the energy, agriculture, and metals sectors and 5% weightings to the timber and water sectors.

WisdomTree Continuous Commodity ETF GCC (0.85% expense ratio) offers more-direct exposure to commodity prices through commodity futures contracts. However, its performance will not perfectly correlate with the underlying commodity prices. It equally weights 17 commodity contracts to improve diversification.

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Reference (1) Bryan, Alex. 2013. "A Fresh Look at Commodities." Morningstar. July 3, 2013. http://news.morningstar.com/articlenet/article.aspx?id=601590

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.