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US: Is It Too Late to Ride the Energy Bandwagon?

by Tim GrayThe New York Times
October 9th, 2005

CHARLES M. OBER'S stock research routinely takes him to places like Libya, Nigeria and Venezuela - countries whose politics have often been as volatile as the price of the oil they pump out of the ground.

Mr. Ober manages the T. Rowe Price New Era fund, a natural-resources mutual fund whose range of investments includes shares of companies that operate in some of the world's least stable regions. His fund is known for steadiness in this jumpy sector. But that element of political risk, which is shared to one degree or another by most natural-resources funds, can make the gyrations of technology funds seem tame by comparison.

Even so, the sector has been popular lately with investors. According to Lipper, the fund tracking company, a net $14 billion entered natural-resources funds in the two years ended in August. In contrast, the funds had a net outflow of $440 million during the previous two years.

Natural resources funds invest in everything from gold miners to timber companies. But oil-related stocks, ranging from drillers like the Apache Corporation to services providers like Halliburton, tend to predominate. Interest in the sector stems from its recent double-digit returns as well as worldwide developments - including the Iraq war, China's torrid growth and Hurricane Katrina - that have pushed oil prices higher and higher.

After lagging behind the broader market during much of the 1990's, natural-resources funds, on average, posted returns of more than 28 percent in the 12 months through September, according to Morningstar. An investor who bought into, say, the Guinness Atkinson Global Energy fund when it began in June 2004 would have had a return of more than 110 percent through September.
With the possible exception of long-term investors who buy shares of a natural-resources fund to diversify a broader portfolio, people who enter the funds now may be setting themselves up for disappointment, some mutual fund experts say.

"It's a perilous time to be starting in this category," said Sonya G. Morris, a fund analyst at Morningstar in Chicago. "Retail investors have a bad track record of joining the party late and buying a fund because of yesterday's hot performance. That isn't a good-enough reason to buy. A fund has to have a role within your portfolio."

These funds are generally more volatile than the Standard & Poor's 500-stock index, according to Morningstar, but Mr. Ober's fund has been an exception. He says he has reduced the fund's ups and downs by allocating fewer dollars to oil-related stocks than many of his peers, instead favoring such companies as Newmont Mining, a gold producer, and even Nucor, a steel maker. Yet, as a result, his fund can lag behind when oil prices rise.

In the 12 months through September, New Era has risen 36.4 percent, which puts it below the 50.8 percent average total return for natural-resources funds tracked by Morningstar. Oil prices, which have more than doubled over the last two years, spiked after Hurricane Katrina battered the drilling platforms and refineries clustered along the coast of the Gulf of Mexico. At the same time, the price of gold - its producers are another natural-resources fund staple - has also been climbing. It hit a 17-year high in late September.

Oil prices can fall just as fast as they rise, of course, and when they drop, they tend to drag natural-resources funds with them, said Andrew Clark, a Lipper senior analyst. "It's not unusual for oil to lose 15 or 20 percent of value in a month. Natural-resources funds don't tend to fall quite as much, but you could see a 10 or 15 percent drop. You have to ask yourself if you're comfortable with that level of risk."

Amid the gush of investor interest and rising prices, the Vanguard Group posted a warning in August on its Web site, cautioning against investments in the energy sector.

(Even so, Vanguard has not closed its energy fund, Vanguard Energy. In fact, it reopened the fund in the summer after closing it to new customers last December.)
Vanguard said that people with diversified portfolios probably already have a big-enough investment in the energy industry. Ms. Morris of Morningstar agreed.

"Most people have a large-capitalization fund as their anchor investment," she said. "Most of those look similar to the S.& P. 500, which has about 9 percent allocated to energy stocks right now. That seems like a healthy, appropriate allocation."

At the same time, recent academic research suggests that investments in commodities, as opposed to commodity-producing companies, may damp the ups and downs of a broader portfolio. That would seem to contradict conventional wisdom. After all, commodities have a reputation as the sort of investment favored by people with a taste for bungee jumping and airplane acrobatics.

"Nobody had ever really studied the commodities market thoroughly, so it had remnants of its reputation from the old days of market manipulation and volatile prices," said Gary B. Gorton, a finance professor at the Wharton School of the University of Pennsylvania.

The reputation appears undeserved, Professor Gorton said. For a paper to be published in the Financial Analysts Journal, he and K. Geert Rouwenhorst, a finance professor at Yale, compiled a 45-year database of commodities returns and compared them with those of the S.& P. 500 index.

They put together a diversified index of commodities and found that it provided a return and volatility comparable to that of the S.& P. 500. And they found that commodity returns were not correlated to stock or bond returns. In other words, when stocks and bonds slumped, commodities did not.

The professors also found that commodities provided better diversification than shares in commodity producers like oil and mining companies. An index of commodity producers tracked the S.& P. 500 more closely than it did the professors' commodities index. Several companies, including Pimco in Newport Beach, Calif., and OppenheimerFunds in New York, offer mutual funds that invest in commodities. Both the Pimco and Oppenheimer versions use commodities indexes as benchmarks: the Pimco Commodity Real Return Strategy fund uses the Dow Jones-AIG Commodity index, while Oppenheimer Real Asset uses the Goldman Sachs Commodity index.

Ms. Morris, the Morningstar analyst, recently made the Pimco fund her only recommendation in a report on natural-resources funds.

The Pimco portfolio resembles that of a bond fund, with most of the money invested in Treasury inflation-protected securities, known as TIPS. The bonds serve as collateral for the fund's investments in a form of derivative security called a commodity swap. Pimco uses the swaps to replicate the performance of the Dow Jones-AIG Commodity index, said Robert J. Greer, a Pimco product manager. "Commodities swaps are more efficient than trying to trade individual futures," he said.

Pimco's fund is "very uncorrelated to the broader stock market," Ms. Morris added. "So it makes a lot of sense as a diversifier."





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