Mutual Funds for High Oil Prices

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NEW YORK (TheStreet) -- With oil prices climbing, you might expect that investors would be racing to buy funds that have big stakes in energy and commodities.

But in the past year, shareholders have followed unexpected patterns, investing in some energy-oriented funds and pulling out of others.

According to Morningstar, investors have put $6.1 billion into commodities broad basket mutual funds, which have 47% of their assets in energy.

At the same time, shareholders have pulled $600 million out of natural resources mutual funds, which have 44% of assets in energy.

Why are natural resources funds unloved? Part of the problem is that the resource funds invest in stocks of energy and commodity producers.

Portfolios hold big integrated oil companies such as Chevron as well as gold miners such as Randgold Resources .

These days many retail investors have soured on equities, pulling money out of most kinds of stock funds. Even though energy companies stand to generate huge profits if oil prices spike, fund shareholders are not interested.

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Many nervous shareholders prefer the broad basket commodities funds. Instead of holding stocks, the funds invest in futures and other derivatives that track benchmarks such as the S&P GSCI commodity index.

There is a clear case for owning a broad basket fund. If commodity prices skyrocket, the funds could climb and help diversify portfolios. But investors should not overlook natural resources funds.

Because the two kinds of funds don't always track each other, it can pay to hold both a natural resources fund and a broad basket portfolio.

Recently the performance records of the different categories have diverged.

During the past five years, natural resources funds have returned 4.1% annually, while broad basket funds have lost 1.3%.

Seeing that record, some investors might decide to only hold a fund that owns natural resources stocks. But keep in mind that natural resources funds tend to be volatile, soaring in bull markets and falling sharply in downturns.

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To appreciate how the records of the funds can differ, compare the performance of Prudential Jennison Natural Resources , one of the largest funds in its category, and Credit Suisse Commodity Return Strategy , a popular broad basket fund.

Both funds suffered in 2008, when the economy sank into recession and commodity prices collapsed. For the year, the Prudential natural resources fund lost 52.9%, while the Credit Suisse broad basket portfolio dropped 35.5%.

When commodity prices came roaring back in 2009, Prudential gained 73.2%, and Credit Suisse returned 20.1%. Helped by its bull market showing, Prudential returned 6.8% annually during the past five years, while Credit Suisse lost 1.5%.

Natural resources stocks are particularly volatile because they are leveraged to commodity prices.

Say it costs a company $80 to produce a barrel of oil that can be sold for $100. Now the market price rises to $120. That would cause the oil company's profits to climb by 100%, and the stock might skyrocket.

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But a fund that holds oil futures may achieve only a 20% gain because it is not leveraged to commodity prices. In a downturn, the reverse process occurs, and the stock could suffer big losses, while the futures fund would suffer a limited decline.

Over the long term, commodity prices rise at about the rate of overall inflation, and broad-based commodity funds tend to match that figure.

Because the resource stocks are leveraged, they can produce returns that are in excess of inflation, says Kevin McDevitt, a Morningstar analyst who argues that investors should consider natural resources funds.

"Ultimately investing is about more than just matching the inflation rate," he says. "You want to beat inflation, and you can do that by investing in commodity stocks."

For a solid natural resources fund, consider BlackRock Natural Resources . During the past 10 years, the fund returned 12.3% annually, outdoing 65% of peers. The BlackRock fund typically has two-thirds of assets in energy.

But lately portfolio manager Robert Shearer has raised the energy allocation to 88% of assets. "There is very little spare capacity in the world," says Shearer. "If there is a disruption in Venezuela or the Middle East, there could be a supply shortage."

Shearer likes companies with sound balance sheets that are low-cost producers. He favors companies that seem poised to increase their production. One holding is Occidental Petroleum . Shearer says that the company can increase its production at a single-digit pace.

He also likes National Oilwell Varco , which supplies rigs to drillers. The company is enjoying growing demand and stronger prices as offshore drilling increases.

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