How Much Upside Is Left in Natural Resources?

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Natural-resource funds, buoyed by the performance of oil, metals, and other basic material stocks, have been on a tear.

These specialized funds were the top-performing US sector group for the third quarter, gaining 7.2 percent, according to fund tracker Lipper. For the five years ending Sept. 30, they advanced by an average annualized rate of 31.3 percent, more than double the S&P 500 stock index's gain. In September, the funds received an additional kick from a sagging US greenback, which fell to a new low against the euro after the Federal Reserve's interest rate cuts. The Fed's action sparked an upswing in commodities and revived fears of inflation. (Commodities are viewed as an inflation hedge.)

However enticing they appear, the sector's recent high returns shouldn't be extrapolated, says Morningstar analyst Michael Herbst. "These funds have had an unusually long winning streak, and you can make a case for them on a longer-term basis. But the funds carry considerably more downside risk than diversified equity funds," he says, because commodity price declines can be swift and sudden. The standard deviation of returns (a measure of volatility) of the typical natural resources fund is more than double that of the average large-cap equity fund, according to Morningstar. "It's a bit risky to chase the performance derby now," Mr. Herbst says.

Still, fund managers say, robust economic growth in emerging markets such as Brazil and China enhances the outlook for commodity producers over the next three to five years. Demand for such basic commodities as oil, copper, and nickel is outstripping supply. The rapid industrialization of emerging economies, along with major infrastructure improvements in roads, power lines, and seaports, is "the key, long-term demand driver for basic materials of all kinds," says Fred Sturm, manager of the Ivy Global Resources Fund. Many resource producers are "struggling to increase capacity after many years of underinvestment in new mining or oil drilling projects," he says.

Even if US economic growth falters and crude oil falls below $80 a barrel, says John Segner, manager of AIM Energy fund, "oil prices should remain well above historic norms. …


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