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Commodities Revive After Long Downturn -- So Which Funds Are Buys?

NEW YORK ( TheStreet ) -- Commodities funds are finally rallying.

This year, commodities broad-basket mutual funds have gained 5.7%, compared to 4.2% for the S&P 500 (SPY), according to Morningstar. The healthy showing represents a huge shift from the recent past. During the three years ending in 2013, commodities funds lost 6.2% annually, compared to a gain of 16.2% for the S&P 500.

Can commodities prices keep climbing? Probably. With economies growing in China and other emerging markets, demand should remain steady for oil, livestock and metals. "The global market for commodities is somewhat tight," says Darwei Kung, portfolio manager of DWS Enhanced Commodity Strategy (SKNRX), a mutual fund. "There is not a lot of spare capacity for many commodities."

Commodities seem likely to stay in the black this year, says Ryan Issakainen, ETF strategist for First Trust Advisors. He says that commodities prices tend to rise during the later stages of economic expansions. At such times, economies gain steam, and businesses bid up prices of materials. The economy has been recovering since 2009, and there is good reason to think that we are entering the second half of the recovery, a period that should favor commodities.

Many retail investors first noticed commodities funds a decade ago. Strong performance attracted the attention. From 1999 through 2005, commodities funds climbed steadily. With economies booming in Asia and Latin America, demand increased for such commodities as copper, agricultural products and precious metals.

As the rally progressed, some financial advisors argued that most portfolios should include at least some commodities because they offered diversification as well as solid returns. Proponents pointed to studies showing that prices of oil and other products sometimes rose when stocks were falling. But as the financial crisis unfolded, commodities funds tanked along with stocks. In recent years, slowing growth in China caused weakening prices for metals and other commodities.

Analysts argue that commodities can still offer some diversification -- though the amount has declined in recent years. To appreciate the role that commodities can play, consider that if two investments move in lockstep, they are said to have a correlation of 1.0. If they never move together, the correlation is 0. Morningstar analyst Timothy Strauts says that in the 1980s and 1990s, the correlation of commodities and stocks was 0. These days the correlation is about 0.5.

"Commodities still make sense because you get a relatively low correlation," he says.

Strauts says that the correlation has increased over the years because of the way that commodities trading has changed. Before 2000, most commodities traders were speculators or people in the industry who wanted to hedge their exposure to certain products. If stocks collapsed, traders had little reason to dump commodities. But in the past decade, many retail investors have begun buying commodities. When markets become volatile, these new traders tend to sell all their holdings -- including stocks and commodities.

As a result, the correlation has increased.

While some commodities funds focus on energy, others are more broadly diversified. Among the energy-heavy mutual funds is Goldman Sachs Commodity Strategy (GSCAX). During the past five years, the fund returned 4.0% annually, compared to 2.7% for its average peer. The fund's benchmark is the S&P GSCI Commodity Index, which weights commodities according to the amount of their production. Since there is considerable production of oil and natural gas, the fund has 71% of assets in energy. Precious metals, which are produced in smaller quantities, account for less than 3% of assets.

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