ETF Opportunity In The Undervalued Natural Resources Sector

| About: SPDR S&P (GNR)
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By Alex Bryan

Despite their volatility, stocks linked to natural resources can provide significant diversification benefits and inflation protection. Natural resources are key inputs whose prices inversely affect the profitability of companies in other industries. As the prices of the commodities they sell rise, natural resources companies become more profitable, which also makes them a good inflation hedge. SPDR S&P Global Natural Resources ETF (NYSEARCA:GNR) offers exposure to this emerging investment theme by tracking the world's 90 largest companies linked to natural resources in the energy, agriculture, and metals and mining sectors. The idea is that by combining exposure to these sectors, this exchange-traded fund can offer investors a smoother ride. A word of caution: The correlations between these sectors are higher today than they have been in the past, as weak global demand driven by the slowdown in China and sovereign debt crisis in Europe continues to depress commodity prices across the board. The fund is a suitable satellite holding for investors who are looking for a high-risk, high-reward way to position for renewed growth in emerging markets and a global economic recovery.

The performance of companies operating natural resources businesses is invariably tied to the prices of the commodities they sell. Commodity prices tend to be more sensitive than the overall equity market to changes in aggregate demand because demand shocks are amplified up the supply chain, as downstream producers order raw materials in bulk ahead of forecasted demand. Most of the fund's holdings have significant operating leverage and cannot quickly adjust production as prices fluctuate. Consequently, the fund's holdings can experience wild swings in profitability. This sensitivity allows the fund's investors to profit handsomely from strengthening demand, but it also introduces substantial risk. However, because the fund derives its commodity exposure through equity securities, its performance will not directly correlate with commodity prices.

Fundamental View
Slowing economic growth in China and prolonged weakness in Europe have weighed on the fund's energy and metals and mining holdings. These markets will continue to drive the fund's performance because they are the largest consumers of many of the commodities the fund's holdings produce. For example, China accounts for nearly 40% of global demand for base metals. Therefore, Chinese infrastructure investments will have a significant impact on the fund's metal and mining stocks. In September 2012, China's National Development and Reform Commission approved a series of new infrastructure projects that many hope will revitalize the nation's economy. However, the local governments responsible for implementing these projects may have difficulty raising the necessary financing, as many are still burdened with debt from the last stimulus round. Unless the labor market significantly deteriorates, the Chinese government is unlikely to pursue an infrastructure investment program on the scale of its 2008-09 stimulus. Such an expansion could fuel inflation and exacerbate the country's existing overcapacity problems. Therefore, Chinese demand for industrial metals and timber is likely to remain soft in the near term.

European Central Bank president Mario Draghi's promise in late July to do "whatever it takes" to save the euro allayed the possibility of an imminent sovereign default. The ECB plans to purchase bonds from the euro's weakest countries in order to reduce their borrowing costs. However, the bank's requirement that these purchases be offset by deposits of equal size will likely limit the stimulative impact of this program. As a result of this continued weakness in Europe and China, the IEA projects that global demand for oil will grow at a modest 1% in 2013. There is significant risk that oil demand may fall short of expectations, which would put downward pressure on oil prices and many of the fund's energy holdings.

The outlook for natural gas prices is more promising. U.S. demand for natural gas power generation is up 24% year over year. While we expect demand to remain healthy in 2013, supply is starting to stabilize as producers continue to curtail unprofitable drilling. The fund's agriculture exposure partially hedges natural gas prices. Natural gas is a significant cost driver for the fund's fertilizer producers, including Mosaic (NYSE:MOS) and Potash (POT). Low natural gas prices allow those producers to keep fertilizer prices low while maintaining profitability.

Demand for agricultural commodities is likely to remain strong. The U.S. is still reeling from the worst drought in 50 years, which has depressed yields and put upward pressure on crop prices. It appears that crop prices have increased enough to offset the negative impact of lower yields on farmers' incomes. If crop prices remain high, farmers will have a strong incentive to plant a large crop in 2013, which should bode well for the fund's holdings in the agriculture sector. The weather has a strong, unpredictable impact on agriculture commodity prices in the short-run. However, long-term demographic changes and demand growth from emerging markets are sustainable tailwinds that will likely continue to push the prices of agricultural commodities higher over the long run.

Portfolio Construction
State Street designed the fund to replicate the performance of the S&P Global Natural Resources Index. This index tracks the 90 largest companies in the agriculture, energy, and metals and mining sectors. S&P selects the 30 largest companies from each sector and weights them by market cap. S&P caps each sector's U.S. and emerging markets exposure at 40% and 15%, respectively. Finally, S&P assigns a one-third weight to each of these sector subindexes and limits individual holdings to 5% of the combined portfolio. Top country weights belong to the U.S., Canada, and United Kingdom, which represent 34%, 13%, and 11% of the portfolio, respectively.

In order to qualify for inclusion in the index, each holding must trade on a developed exchange and meet minimum liquidity requirements. The index is reconstituted annually in August and rebalanced quarterly.

The fund charges a reasonable 0.40% expense ratio, which is low relative to its peers. The fund's holdings are highly liquid, which should keep tracking error and market-impact costs to a minimum. However, over the past year, trading costs and imperfect replication of the index pushed the fund's estimated holding costs significantly above its expense ratio. State Street engages in share lending, the practice of lending out the underlying shares in exchange for a fee. It passes through 85% of the proceeds to investors, which partially offsets the fund's other costs.

There are not many global equity natural resources funds on the market that can match GNR's balanced sector exposure and low fees. However, Market Vectors RVE Hard Assets Producers ETF (NYSEARCA:HAP) is the closest substitute. HAP tracks companies that generate more than 50% of their revenues from the production of commodities. Its portfolio rests on a broader base of more than 300 securities across six hard-asset sectors. However, over the past two years, HAP had a 0.99 correlation with GNR. HAP charges a comparable 0.48% expense ratio.

Investors looking for similar exposure and extra income might also consider WisdomTree Global Natural Resources (NYSEARCA:GNAT). GNAT specifically targets dividend-paying companies in natural resources industries and weights its holdings by dividend yield to maximize income. However, this weighting approach can skew the portfolio toward distressed holdings, which may increase the portfolio's risk. The fund's small asset base may limit liquidity for investors who do not have the scale to trade the underlying basket. GNAT charges a 0.58% expense ratio.

iShares S&P North American Natural Resources Sector Index (BATS:IGE) might also be worth considering. Although the fund restricts its holdings to companies based in North America, global demand determines the prices of the commodities they sell. Therefore, this fund exposes investors to similar macro risk as a global fund. Relative to GNR, IGE carries a much greater exposure to the energy sector, which currently accounts for more than 75% of the portfolio. IGE charges 0.48%.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.