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Not too late to jump into resource sector

If you're smart and can abide setbacks, it remains attractive, ROB CARRICK writes. But making sense of the outlook isn't easy amid the hype and uncertainty

Those endless headlines about soaring oil prices finally hit home with investors last month when they made natural resource funds one of the hottest categories in fundland.

Nice timing, guys. Oil prices have been soaring for three years and metal prices have been riding a multiyear rally of their own. How much more upside could there possibly be?

The short answer to this question: enough. As long as you're smart about it and can tolerate setbacks along the way, the resource sector remains attractive.

Making sense of the outlook for the resource sector is the hardest job in investing right now because of the interplay of hype over commodity investing and uncertainty about where supply and demand are going.

Have global oil reserves peaked? Will demand from the growing economies of China and India keep inflating prices for a range of commodities? Has the easy money been made already?

These questions were weighed by fund company Guardian Group of Funds recently and the result was a new resource fund introduced in January called GGOF Resource.

"One of the questions we've had is: 'Isn't it a bit late?' " said Gavin Graham, Guardian's director of investments. "People are saying that things have been going up for three years, oil's gone up from $18 [U.S.] to $55 and copper's at a 15-year high."

Like all players in the resource game, Mr. Graham is well armed with statistics to make the case that there are more profits to be made in resources. But for every bullish analysis of the resource sector, there's a counterargument that either suggests caution or outright avoidance right now.

Caution has dominated the thinking of Canadian investors in the past few years, which explains why income-oriented mutual funds have generated the most sales. Resource funds have been somewhat popular, but they really broke out in February as many people made investing decisions for their registered retirement savings plans.

Resource funds were the sixth most popular category in February, generating net new sales of $241.6-million (Canadian). But resources were actually the hottest fund category using measures that look at where investors placed new money and money transferred from other categories.

"The spike in oil prices of late has really, really pushed resources to the forefront and galvanized people's attention," said Ian Filderman, director of mutual funds for Bank of Nova Scotia's wealth management arm. "Unsurprisingly, investors are chasing some pretty hot performance."

The compound average annual one-year return from a natural resources fund to Feb. 28 was 33.7 per cent, while the average annual five-year return was 22.3 per cent. The momentum continues, as shown by the sector's average one-month gain of 12 per cent.

Mr. Filderman said it's probably not too late for active, nimble investors to buy into resource funds because, theoretically, they can limit their losses if the sector weakens. But he's less certain about whether it's a good idea for buy-and-forget investors.

"I don't know that I'd say it's too late for resource funds, but it's not exactly the first or second inning of a nine-inning baseball game," he said. "It's a lot closer to the later innings than it is to the early innings."

If you're scoring the resource boom, we have seen double-digit gains in five of the past six years. Rallies this long and intense tend to end badly, so be prepared. The last time resource funds went sour -- in 1997 and 1998 -- the category's average losses were 10 and 30 per cent, respectively.

Don't make a move into resource funds without first taking a look at what stocks are held by your equity funds and any funds you own with lots of exposure to income trusts. The reason is that many of the prominent funds in these categories have significant exposure to resources.

Take the Canadian equity fund category, for example. The $3.8-billion RBC Canadian Equity Fund had 30.5 per cent of its assets in oil, metal and gold stocks at the end of February, while the $3-billion CI Harbour Fund had almost 34 per cent invested in oil, metal and forestry stocks. The $2.5-billion AGF Canadian Large Cap Dividend Fund had 27 per cent in oil, metal and gold stocks as of Jan. 31.

Be sure to check your global equity funds as well because some have modest exposure to resources. For example, the $2.2-billion Fidelity International Portfolio had 16.3 per cent of its assets in oil and metal stocks at the end of January.

Oil and gas royalty trusts account for about 51 per cent of the S&P/TSX capped income trust index, so you're likely to run into them in most funds that invest in income trusts, either exclusively or in a mix with dividend stocks and bonds. Energy trusts are no different from energy stocks in that their fortunes rise and fall with oil and gas prices.

After examining your current fund holdings, you may well find that you're amply exposed to resources already. If you're tempted to get more exposure, remember that many investors were hammered in stereo when tech stocks collapsed because they owned both technology sector funds and mainstream equity funds with a heavy tech component.

If you haven't much resource exposure and you'd like to get some in a conservative way, Mr. Filderman suggested you consider a pair of funds that focus on stocks showing the most momentum in increasing their profits. Resource stocks are hot now, so these funds currently have large holdings in this sector.

"These funds are a way to avail yourself of the resource trend and have a bit of a safety net, so that when the earnings momentum begins to show up elsewhere in the market, the manager is going to move elsewhere," he said.

One of the funds is AIM Canadian Premier, which was about one-third invested in oil and metal stocks at the end of February. The other is Synergy Canadian Class, which had 27.5 per cent of assets in resource and precious metal stocks.

If you're looking for a pure resource fund, Mr. Filderman suggested Mackenzie Universal Canadian Resource. "The manager of this fund [Fred Sturm] is not the guy at the top of the charts, but I trust him from a downside risk perspective. You're already taking enough risk with this sector, so I don't think you need to take more risk with an aggressive manager."

Independent fund analyst Dave Paterson said his favourite resources funds are Mackenzie Universal Canadian Resource and Trimark Canadian Resources because they're among the least volatile in the category. He prefers diversified resource funds like these to those that specialize in energy stocks.

"I like the more general resource funds over a pure energy fund because the manager has some flexibility," he said.

Guardian's new fund was built for risk-averse investors by mixing resource stocks, resource-oriented income trusts and high-yield bonds issued by resource companies. The fund is expected to be more stable than straight resource funds in down markets and will offer additional stability by making quarterly income payments yielding about 2 to 2.5 per cent on an annual basis.

"Here's the boring way to play resources," joked Guardian's Mr. Graham. A boring resource play? No such thing.

The Lowdown on Resource Funds

$4.25-BILLION

TOTAL ASSETS IN RESOURCE FUNDS

18

RANKING OF RESOURCE FUND ASSETS AMONG ALL FUND CATEGORIES

1

GROSS SALES RANKING OF RESOURCE FUNDS AMONG ALL FUND CATEGORIES

50.8%

WORST FUND LOSS THAT YEAR FOR A FUND STILL AVAILABLE (TD ENERGY)

6

NUMBER OF CONSECUTIVE YEARS OF POSITIVE RETURNS FROM RESOURCE FUNDS, INCLUDING 2004

7

NUMBER OF YEARS THE AVERAGE RESOURCE FUND RETURN WAS NEGATIVE IN THE PAST 20

367.8%

INCREASE IN GROSS SALES OF RESOURCE FUNDS IN FEBRUARY

33.7%

AVERAGE ONE-YEAR ANNUAL RETURN FROM RESOURCE FUNDS

11.4%

AVERAGE 10-YEAR RETURN

3.8%

AVERAGE 10-YEAR RETURN AS MEASURED FOR THE PERIOD ENDING FEB. 28, 2003

37

NUMBER OF RESOURCE FUNDS AVAILABLE FIVE YEARS AGO

67

NUMBER OF RESOURCE FUNDS NOW AVAILABLE

SOURCES: MUTUAL FUND ANALYST FRANK HRACS; GLOBEFUND.COM

© 2007 The Globe and Mail. All rights reserved.

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