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
, according to
. Other popular ETFs that have lagged mutual funds in the past year include
PowerShares DB Commodity Index
U.S. Natural Gas
. 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
by 8 percentage points. As the markets recovered, commodities also revived. But many ETFs delivered anemic results.
United States Oil
, 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.
Make no mistake, resource funds can deliver rough rides. If the price of oil drops, stocks of oil producers can fall even further as investors anticipate hard times to come. But good portfolio managers can take advantage of the volatility, buying shares when they are depressed.
For a contrarian fund, try
Franklin Natural Resources
, which has returned 9.9% annually during the past 10 years, outdoing the S&P 500 by 10 percentage points. As energy prices climbed in the spring of 2008, the Franklin managers began selling their holdings of richly valued companies involved in exploration and production of gas and oil. Late in the year, energy prices collapsed, and the fund shopped for depressed shares. "We reduce positions when things are getting overvalued, and we buy when things look ugly," portfolio manager Fred Fromm says.
These days Fromm has been buying oil-service companies, which provide the equipment and services supporting drilling and production. New technology is making it possible to produce oil and gas from fields in the U.S. that were once difficult to exploit. The new fields are proving profitable, but require heavy investments in equipment and services. That is boosting service leaders, including
, Fromm says.
For broad exposure to resources markets, consider
Van Eck Global Hard Assets
, which has returned 15% annually during the past 10 years. Besides energy stocks, the fund also holds producers of precious metals and minerals. Van Eck prefers solid companies that seem likely to grow. "If a company has quality assets, it should be able to survive -- no matter what direction commodity prices take," portfolio manager Charl Malan says.
A favorite holding is
, which produces gold in West Africa. The company has little debt and plenty of cash, so it can easily fund future expansion, Malan says .
Another solid fund is
BlackRock Natural Resources
, which returned 12.3% annually during the past 10 years. Portfolio manager Robert Shearer favors shares that stand to benefit from growing demand and limited supplies. These days he is buying stocks of companies engaged in exploration and the production of oil. Shearer figures demand for oil is increasing in China and other emerging markets. But growth in supplies is limited because of the moratorium on drilling in the Gulf of Mexico. "As the spare capacity declines, we will see an upward bias in oil prices," he says.
A favorite holding is
, which has been acquiring fields in North America and boosting production in Egypt. He also likes
, which is increasing production in California.
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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.