The Big Screen: The Leading Natural Resources Funds

How things have changed. Janus, the suddenly wrinkled king of growth investing, is talking up "black gold" in its TV ads. Natural resources funds (remember them?) are quietly topping the charts.

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In honor of the tech sector's ongoing wake, let's look at natural resources funds: where they invest, how they're performing, what's driving their returns and a few choice offerings that might be worth a look if you're in the mood to invest in messy stuff that comes out of the ground and not from Silicon Valley.

Natural resources, or energy, funds have a long menu of stocks from which to choose. They typically invest in stocks of companies that look for, refine and/or sell oil and natural gas, but they can also buy stocks of shops that make chemicals, sell lumber, make paper, mine coal, build power plants or make new age power sources like fuel cells.

Investors and advisers tend to use these funds, the fortunes of which often rise and fall with commodity prices, as a hedge against inflation and falling stock prices. Indeed, they tend to rise and fall with the S&P 500 only 25% of the time, according to Dan McNeela, the Morningstar fund analyst who covers the group. Despite their utility, these funds' often tame returns make them less than sexy.

"We used to use them in the portfolios, and clients and hated them," says Ron Roge, a financial planner with R.W. Roge in Bohemia, N.Y. "I think they got impatient with the fact that they weren't performing when the market was. I like having them in the portfolios, but clients were used to 20% and 25% returns, so they didn't like these."

They might be more interested now. The average natural resource fund is up almost 28% over the past 12 months, beating the S&P 500 by some 40%, according to Morningstar. They're flat since Jan. 1, but that's good enough to be this young year's second-best performer, behind small-cap value funds.

Natural Phenomena Natural resources funds have charted quite a different course from the broader market.

Source: Morningstar. Annualized performance figures through Mar. 13.

The reason behind the natural resources funds' success is the natural gas sector, where shrinking reserves and rising demand have boosted gas and stock prices.

"We've been overweighted in natural gas for 18 months or so," says Bob Shearer, manager of the (MAGRX Quote)Merrill Lynch Natural Resources fund, which is up 36.8% over the past year. "We look for commodities coming into a tight supply-demand scenario. The supply and demand fundamentals [for natural gas] in North America are good."

The positive supply-demand scenario is being driven by the confluence of several factors, according to Shearer. For instance, natural gas pipelines haven't expanded in recent years, limiting production a bit. At the same time, demand is rising as new power plants built by shops like Calpine(CPN Quote) generate electricity from natural gas-powered turbines. Rising demand for natural gas to generate electricity in states such as California, where power generation isn't keeping up with demand, has boosted demand and natural gas prices.

Shearer thinks prices will stay up for 12 to 18 months, depending on various factors including the weather, like a hot summer following the cold winter, which would drive demand higher. His top-two picks in his fund are natural-gas producer and marketer EOG Resources(EOG Quote) and oil and natural-gas well operator Devon Energy. Those stocks are up 150% and 44.8% over the past 12 months, according to Morningstar.

Another driver of performance is industry consolidation. The most recent example is Shell's hostile bid to buy oil and natural-gas producer Barrett Resources(BRR Quote), whose shares are up 155% over the past year.

And more mergers may be on the way.

"Producers of oil and gas have cheap stocks," says Robert Mullin, manager of Marathon Resource Partners I, a natural resources hedge fund from San Francisco-based Aesop Capital Partners. "In many cases, companies' assets are worth more than they're trading for. I think consolidation will continue."

Current favorites he's been buying the past two weeks are natural-gas shops such as Evergreen Resources(EVG Quote), Mitchell Energy & Development(MND Quote) and Louis Dreyfus Natural Gas(LD Quote). He thinks the managers of these companies "are shareholders who will sell the business at the right price."

In such a tough market, investors are beginning to wrap their arms around these wallflower funds.

"A year ago, it looked like resource funds would be a dying breed," says Merrill's Shearer. "Fundamentals were excellent, but we were in net redemptions. But we've had net inflows since late in the fourth quarter."

But before you buy shares of one of these funds, it's important to remember that -- like all sector funds -- they only deserve some 5% or so of your portfolio, and they only make sense for investors willing to hold them for at least five years.

"They can be very volatile funds," Morningstar's McNeela says. "You only need a small percentage of your portfolio there."

Volatile indeed, because they are tied to commodities prices. Yes, these funds' annualized returns look fairly tame, but it wasn't a smooth ride. The average natural resources fund beat the S&P 500 in four of the past 10 calendar years, but the group did drop 25% on average in 1998, according to Morningstar.

Separate Ways Natural resources funds haven't mirrored the broader market.

Source: Morningstar

If you're looking for a natural resources fund or want to check out what the leading funds in this tribe own, check out Part 2.