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The Conundrum

Natural resource equities are a popular way for investors to gain exposure to commodities and they have recently garnered significant attention as a possible hedge against core inflation. Natural resource stocks have historically shown higher correlation relative to equity markets as compared with commodities futures, but nevertheless provide higher return potential due to attributes such as operating leverage and no explicit risk of contango.

However, it is a challenge to select an active fund in this category as most natural resource funds incorporate a top/down overlay in their investment process and are thus subject to significant risk of under-performing their respective benchmarks.

The following chart compares performance for the S&P: North American Natural Resources Index against the Lipper: Natural Resources funds peer group.

Returns as of 12/31/2010

10 yrs Annualized

5 yrs Annualized

3 yrs Annualized

1 Year Annualized

Lipper: Natural Resources funds

10th Percentile

11.89%

8.04%

-1.43%

28.86%

25th Percentile

9.97%

7.06%

-2.70%

23.87%

Median

8.94%

5.98%

-3.59%

20.93%

75th Percentile

8.24%

5.40%

-6.21%

18.10%

90th Percentile

5.95%

4.27%

-8.53%

15.90%

S&P North American

9.96%

8.99%

-0.71%

23.88%

Natural Resources Index

26th percentile

1st percentile

3rd percentile

25th percentile

As we can see, the benchmark outperformed about 75% of the funds in this category over the past 10 years and nearly 99% of the funds over 5 years. Even though there are stellar performers such as the Prudential Jennison Natural Resources funds (PNRZX) and Blackrock Natural Resources fund (MDGRX), both these funds, along with most of their outperforming peers, have done so with significantly higher volatility.

Also, the expense ratio for funds within this category is about 1% (1), which is significantly higher than 0.48% for the iShares S&P North American Natural Resources ETF (IGE) and 0.4% for the SPDR S&P Global Natural Resources ETF (GNR) which track the referenced benchmarks. This further bolsters the argument that it may indeed not be worthwhile for the investor to select an actively managed natural resources fund.

What are Progressive Commodities?

Progressive commodities are extensions of the commoditiesuniverse which are likely to constitute a larger share of the cap-weighted benchmark over the next decade. Returns for these commodities are likely to be driven by distinct themes as the commodities universe matures and the world adapts to shrinking reserves for traditional commodities.

Traditional commodities can be broadly classified into Energy, Metals and Mining and Agricultural commodities, and supplementing the core holdings in each of these sub-sectors with progressive commodity ETFs might allow the investor to capture the alpha as the underlying themes stabilize.

1) Energy: Alternative energy is considered a progressive commodity sector in this space and most active natural resources funds much like the benchmark primarily provide exposure to oil and gas producers & service providers. The alternative energy space is, however, inundated with numerous products and most of them havent been around long enough. Also, the 3 year performance on these diversified clean energy ETFs range from -1.4% to -30% and seem chaotic enough to keep most investors away.

However, there are explicit differences in the way these ETFs are structured and the investor needs to keep in mind that selecting a clean energy ETF isnt remotely similar to selecting a sector or county ETF. Some popular diversified clean energy ETFs are listed below:

Fund

Focus

Investment horizon(2)

3 year return

Correlation to global equity market

International exposure

Powershares Wilderhill progressive energy portfolio (PUW)

Transitional Bridge technologies to improve near-term use of Fossil Fuels

Intermediate

-1.4%

Higher

25%

Powershares Wilderhill Clean Energy ETF (PBW)

Companies involved in substitute technologies such as Solar, wind and Energy storage

Long

-27.8%

Lower

25%

Mkt Vectors Global Alternative Energy ETF (GEX)

Global companies involved in substitute technologies such as Solar, wind and Energy storage (1)

Long

-30%

Lower

60%

(1) GEX invests about 30% in developed Europe versus 2% for PBW.

(2) In the context of this discussion, the investment horizon is defined as the time period over which the investor can expect the fundamental consolidation of excess returns for these ETFs over their core traditional natural resources' equities indices. We consider 5-7 years as intermediate and 10-12 years as the long term horizon.

2) Materials: Rare earth metals are progressive commodities within materials. With applications ranging from advanced data storage to alternative energy, these metals are primarily a long to intermediate term technology play if we consider only the demand side of the equation. However, China is the worlds leading producer of rare earth metals and prices for these metals are prone to intermediate supply shocks which can lead to higher volatility. Nevertheless, an investor in this sector can significantly enhance returns for his natural resources equitiesportfolio as the underlying themes stabilize over the next decade.

Van Eck Global introduced an equities based rare earth / strategic metals ETF (REMX) late last year to add to its array of niche passive products. The ETF tracks the Market Vectors Rare Earth / Strategic Metals Index and provides modified cap weighted exposure to 25 companies which produce rare earth and strategic metals. As the name suggests, the ETF is not a pure play for rare earth metals as the core businesses for some of its holdings - such as Titanium Metals Corp. (TIE) and Osaka Titanium Technologies - are not exposed to the 17 popular rare earth elements. An investor willing to accept some idiosyncratic risk can consider direct investment in core producers of rare earth commodities such as MolyCorp Inc. (MCP) and Lynas Inc (OTCPK:LYSCF), however REMX is a fine option.

3) Agribusiness: IGE has a significant underweight to the agribusiness sector and allocates less than 5% of the total portfolio to these companies which might detract from performance as many analysts project increased demand for agricultural commodities over the next decade. Most actively managed natural resource funds have also consistently maintained a similar position with regards to the agribusiness sector due to their focus on quarterly & annual returns relative to the benchmark & their peers. In contrast, the GNR allocates about a third of its portfolio to agribusiness firms and provides a higher level of diversification as long as the investor is comfortable with the corresponding international exposure.

A few options in the agribusiness segment are below:

Fund

Ticker

Expense ratio

Average Market capitalization

International exposure

Powershares Global Agribusiness ETF

PAGG

0.75%

$16 billion

72%

Market Vectors Agriculture ETF

MOO

0.56%

$15 billion

60%

IQ Global Agribusiness small cap ETF

CROP

0.75%

$2.4 billion

0%

An investor with a holding in GNR can consider the IQ Global Agribusiness small cap ETF to supplement their core agribusiness holdings. The fund is also focused on the North American region which makes it a fine option for an investor in GNR who might seek to limit their international exposure.

Sample Portfolio

S&P North American Natural Resources ETF

(IGE)

70% of portfolio

Diversified Clean Energy ETF

(PBW)

10% of portfolio

Rare Earth and Strategic Metals ETF

(REMX)

10% of portfolio

Agribusiness Segment ETF


(MOO)

10% of portfolio

Source: Progressive Satellite ETFs for Your Natural Resources Equity Portfolio