The natural resources mutual fund sector has a number of attractions, but one characteristic that is probably not immediately evident to many investors is that these funds do not correlate closely with broad stock indexes. This, it turns out, is a valuable feature.
As defined by Morningstar, natural resources funds "focus on commodity-based industries such as energy, chemicals, minerals and forest products in the U.S. or outside of the U.S. Some portfolios invest across this spectrum to offer broad natural resources exposure. Others concentrate heavily or even exclusively in specific industries, including energy or forest products." Unlike a commodities fund, which uses futures contracts, a natural resources fund purchases the shares of companies that are involved in the mining, refining, packaging or transporting of commodities.
As of April 30, only 18 mutual funds classified by Morningstar as natural resources funds had 10 years of performance history. These funds are listed in the Go Natural chart below. The correlation of each fund's monthly returns with the S&P 500 is shown, as well as the 10-year average annualized return as of Dec. 31, 2011.
There is a clear pattern between a fund's correlation with the S&P 500 and its return in the 10-year period from Jan. 1, 2002, through Dec. 31, 2011. Natural resources funds with lower correlations (that is, closer to zero) had better performances during this span.
Of course, this does not imply the same relationship will apply going forward. The 10-year average annualized return of the S&P 500 Index from 2002 to 2011 was only 2.92%. That means any mutual fund (not just natural resources funds) with a high positive correlation to the S&P 500 was, in almost every case, doomed to modest performance over those 10 years.
ALTERNATIVE TO WHAT?
Generally speaking, the core asset of many portfolios is a broad exposure to U.S. companies - such as a fund that mimics a broad-based equity index (like the Russell 1000, the S&P 500 or the MSCI U.S. Large Cap 300). Natural resources funds are typically lumped into an investment class referred to as alternative assets. As a result, a resources fund may provide an alternative to the core equity positions in a portfolio. Given the strong returns over the past 10 years for natural resources funds, one might wonder why they would be merely an alternative.
Natural resources funds tend to have lower correlation with traditional U.S. large-capitalization equity funds than mid-cap and small-cap U.S. equity funds have with large-cap funds. Indeed, the correlation of many mid-cap and small-cap U.S. equity funds with U.S. large-cap equity funds is often more than 90%. By comparison, most of the natural resources funds highlighted here had a 10-year correlation of less than 80%.
Assembling a portfolio with ingredients that have low correlation with one another is vital to achieve the benefits of diversification. There are many examples of the importance of low correlation among the components of a system. In sports, for example, a basketball team needs players with different attributes and talents. Building a basketball team with five point guards is not a great idea, even though point guards are highly valued. A center is also needed, as are forwards. Because they have different attributes and talents, the correlation between a point guard and a power forward is low - and low correlation is what a basketball coach is after. Low correlation between the various parts of a system equals diversification.
The maximum correlation between two parts of a system is +1 (or 100%), and the minimum correlation is -1 (or minus 100%). A correlation of +1 indicates that the behavior of the two parts is very similar (like, say, twin brothers who both play point guard).
A correlation of -1 indicates that the two parts behave very differently (say, a left-handed 6-foot-1 point guard and a right-handed 7-foot-4 center). A correlation of zero indicates that the behavior between the two parts is basically random.
As it pertains to investment portfolios, correlation between two assets within a portfolio is measured in the range of +1 to -1, where +1 indicates perfect positive correlation. When one goes up, the other goes up. For a correlation of -1, the price movement of two assets is perfectly inversely related. When one goes up, the other goes down, and vice versa. A correlation coefficient of zero indicates no correlation between the assets.
When building investment portfolios, the goal is to minimize the number of high correlations (more than 0.7) between various assets in the portfolio. A correlation of 0.7 between two assets indicates that 70% of their behavior is similar. Eight of the natural resources funds in this study had a 10-year correlation with the S&P 500 below 0.7. (There are many other natural resources funds that were not included because they do not have a 10-year performance history.)
MEASURING EACH FUND
Let's consider how each of the 18 natural resources funds contributed to the overall performance of a diversified portfolio over the past 10 years (2002-2011). The 12-asset portfolio consisted of equally weighted allocations (8.33%) in the following asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, real estate, natural resources, commodities, U.S. bonds, TIPS, non-U.S. bonds and cash. The performance of 11 of the 12 asset classes was represented by an established index. For the natural resources component, each of the 18 natural resources funds was used, one at a time.
Individually, the annual return of each natural resources fund was inserted into the 12-asset model and the 10-year performance of the entire portfolio was calculated. The results are shown below in the Portfolio Performance chart.
The performance of the 12-asset portfolio assumes annual rebalancing among all 12 components to restore an 8.33% allocation for each. (It should be noted that it is possible to rebalance too frequently. In this 12-asset portfolio, rebalancing the portfolio annually using index returns for all asset classes generated a 10-year annualized return that is 20 basis points higher than would have been achieved if that rebalancing had occurred monthly from 2002 through 2011.)
At the other extreme, a 12-asset portfolio that was never rebalanced would have had a return that was 44 basis points lower than the annually rebalanced portfolio. When working with tax-sheltered accounts, well-timed rebalancing essentially assures higher returns.
Despite substantial performance differences among the individual natural resources funds, the 10-year annualized return of the overall 12-asset class portfolio was largely unaffected by which natural resources fund was picked. The most dramatic performance differences at the portfolio level were observed when using U.S. Global Investors Global Resources (9.89% annual return for the portfolio) and Materials Select Sector SPDR (8.58%).
If a natural resources fund was left out of the overall portfolio, the 10-year annualized return of the remaining 11-asset portfolio was 8.65%, with a 14.5% standard deviation. In every case but the Materials Select Sector SPDR, the inclusion of a natural resources fund in the portfolio led to better 10-year performance. (It also resulted in slightly higher volatility, as measured by standard deviation of the annual returns.)
These results illustrate a vitally important point: The asset allocation model is more important than the individual fund being used in the model. In short, there are a number of perfectly adequate natural resources funds - just pick one of them. The important issue is to incorporate natural resources to achieve a diversified portfolio.
Craig L. Israelsen, Ph.D., is a Financial Planning contributing writer and an associate professor at Brigham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.