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For Oils, Metals, Buy Mutual Funds, Not ETFs

Stocks in this article: GHAAX MDGRX OXY

To bet on the outlook for oil and metals, you can buy either commodity ETFs or natural resources mutual funds. Lately, many shareholders have preferred ETFs, which have attracted $7.3 billion in inflows this year. Mutual funds have received only $742 million. But those who favored ETFs have been disappointed.

During the past year, the average resource mutual fund has returned 12.8%, compared with a return of 0.9% for iShares GSCI Commodity Index ETF (GSG), according to Morningstar (MORN). Other popular ETFs that have lagged mutual funds in the past year include PowerShares DB Commodity Index (DBC) and U.S. Natural Gas (UNG). Besides delivering subpar returns, the ETFs have also failed to provide much diversification.

The ETFs began gaining popularity in 2007 as shareholders became convinced commodity prices would rise along with demand from emerging markets. Even if prices didn't climb much, investors figured commodities would provide diversification because that had often been true in the past. During the 1980s and 1990s, commodities sometimes rose during periods stocks languished.

But as the credit crisis unfolded, commodities suffered along with nearly every other investment. In 2008, the iShares GSCI Commodity Index lost 45.8%, trailing the S&P 500 by 8 percentage points. As the markets recovered, commodities also revived. But many ETFs delivered anemic results.

Consider United States Oil (USO), an ETF with $1.9 billion in assets that tracks the price of a barrel of crude. Last year oil doubled, rising from $33 a barrel to more than $66. But the oil ETF only returned 18.7% for the year, trailing the average natural resources mutual fund by 30 percentage points.

The poor results can be traced to the way the oil ETF is designed. Instead of owning actual barrels of oil, the ETF holds futures. The portfolio managers typically buy and hold one-month futures contracts, which represent bets on the future price of oil. Near the end of the month, the managers sell the futures and buy new one-month contracts.

The problem is that many other managers are making the same trades. As a result, futures are depressed during periods of selling. Prices become inflated when many managers buy the same contracts at once. That hurts returns.

In some cases, a manager may sell a contract for $50 and buy one for $60. Traders call this unprofitable situation contango. Because of contango, ETFs deliver skimpy results in rising markets. Scott Burns, Morningstar's director of ETF research, says he has stopped recommending commodity ETFs that hold futures. "Until we get out of contango, I would not buy commodity ETFs," he says.

To avoid problems in futures markets, you can own resource mutual funds, which hold stocks of energy and metals producers. Top mutual funds have outdone ETFs by wide margins. The funds sometimes provide important diversification, since resource shares can rise when other sectors are declining.

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