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In resources? Always be ready to rush for the exits

Natural resources funds are a natural wonder right now.

While the broad stock indexes have basically done nothing recently, resource funds have gone ballistic. For the six months ended March 31, the average gain was 29.3 per cent. Even the last-place fund over this time period, StrategicNova Canada Dominion Resource, was up 11.3 per cent.

The outlook for these funds over the coming months seems pretty good, so there's probably time to get in if you haven't already.

Don't plan to linger, though. Natural resources funds can be wonderful when things are going great, but they're death to buy-and-hold investors.

You can see this plainly in the longer-term performance numbers for resource funds.

Over the five years to March 31, resource funds lost an average 1.9 per cent a year. Of the 24 funds with a five-year record, 15 were underwater for the period.

Go back 15 years and you'll find the compound average annual return for resource funds was 2.6 per cent. This isn't surprising, given that these funds lost money on average in six of those 15 years, or 40 per cent of the time.

A classic slump for natural resources funds occurred in the late 1990s. In 1997, the average loss for the category was 14.3 per cent. Then, as the Asian economic crisis developed in 1998, the average fund fell 31.2 per cent. An investment of $1,000 made at the beginning of 1997 would have been worth $589 at the end of 1998.

The economically stagnant years of 1990 and 1991 were almost as tough on resource funds, delivering annual average losses for the category of 14 and 3.5 per cent.

The reason investors put up with this abuse is the possibility of big scores that are almost out of the question with standard equity funds. In the golden year of 1993, the average resource fund return was 69.4 per cent. The best fund that year, Mackenzie Universal Canadian Resource, made 89 per cent.

Resource funds had solid gains in the mid-teens during 1999 and 2000, then a modest 4-per-cent return last year on average. Now, these funds are on a tear again that could well last through 2002.

Up to now, the stocks that resource funds buy have been powered in large part by strong gold and oil prices.

The outlook for gold is hard to pin down, given that the sector has been a safe haven for investors troubled by unrest in the Middle East and treacherous stock markets.

Craig Porter, manager of the $82-million Altamira Resource Fund, said it's possible investors will move out of gold and into hotter-performing areas as the economy picks up. He also notes that higher interest rates could hurt gold prices.

Energy stocks have been helped by a jump in the price of oil caused by events in the Middle East. Mr. Porter says that even if prices come down, oil producers will still have benefited through higher-than-expected revenues for the current year. This could translate into more exploration and merger and acquisition activity, which is bullish for the sector.

Looking ahead, the juice for resource funds in 2002 will come from metal and forestry stocks, which are tied to the fortunes of the economy. Mr. Porter said some of these stocks have already started to rise in anticipation of stronger demand for raw materials.

"As the economy starts to recover a bit more, then more economically sensitive stocks like papers and metals will do better," he said.

All right, a reasonable argument can be made for buying resource funds now. But what about your exit strategy?

A key barometer for metal and forestry stocks is industrial production, Mr. Porter said. "That's what people are watching right now as they start to buy the metals and the trees."

Last week, a barometer of manufacturer sentiment from Statistics Canada reached its highest level since summer, 2000. This suggests that there will be further increases in output by manufacturers in the months ahead.

The time to get out of resource stocks is when growth in industrial production or broader economic output starts to level off. By then, Mr. Porter said, investors will be moving out of resource stocks and into high-growth stocks. Higher interest rates can both help and hinder resource stocks, Mr. Porter added.

"People look at rising interest rates and say, we should be owning the metals if the economy is booming because there's going to be a lot of demand there," he said. On the other hand, higher mortgages rates would quell demand for housing and, in turn, lumber.

A basic way to protect yourself from a downturn is to keep a tight limit on your exposure to resource funds. Five per cent will do for the majority, while 10 and maybe 15 per cent would be the high end.

Enjoy the runup in these funds, but be sure to sell before they inevitably decline. If you buy and hold, it will end badly.

© 2007 The Globe and Mail. All rights reserved.

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