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Tuesday, 31 May 2011

Funds That Are Avoiding Commodities

David Kathman, CFA

As the world economy moves forward in fits and starts, commodity prices have continued to be among the most closely watched economic indicators. For most of the past year, commodity prices have been on the rise, thanks to anticipated demand from emerging markets and a desire to hedge against inflation and the falling dollar. In recent weeks, though, they've pulled back significantly due to various factors, notably the European sovereign debt crisis and concerns that developing markets such as China may not grow as fast as expected. This pullback has contributed to short-term declines in the broader market, but it could be good news for the U.S. economy, because high oil prices have started to crimp the budgets of drivers, potentially slowing the recovery.

Given the runup in commodities and commodity-related stocks over the past year, they've been popular with many mutual fund managers. A couple of weeks ago, we took a look at some good diversified funds with above-average commodity exposure relative to their peers. On the other side of the coin are fund managers who have avoided commodities, either for strategic reasons or because they think prices have become stretched and there are better opportunities elsewhere in the market. It's no surprise that funds specializing in sectors such as financials or technology don't own commodity-related stocks, but there's no shortage of diversified funds, including some run by smart managers with very good track records, that are mostly steering clear of commodities.

To broaden the scope a bit, we looked at funds with the least exposure to basic materials, energy, and industrial stocks. The following table shows the 10 funds in the nine Morningstar Style Box categories with the lowest combined percentage of their most recent portfolio in those three sectors. We've left out index funds and those with less than $100 million in assets and show each fund's percentile ranking in its category for the year to date and the trailing three years, both as of May 26.

Click here to view the table. http://news.morningstar.com/articlenet/article.aspx?id=382658

This is a fairly eclectic group of funds, in categories ranging from small growth to large value. Thus, it's significant that most of them (with a few notable exceptions) have great three-year returns, ranking near the top of their categories, but terrible returns so far in 2011, ranking near the bottom. The lack of exposure to commodities or commodity-related stocks is undoubtedly a factor in this poor recent performance, given how hot those areas have been. Beyond that, though, these funds differ quite a bit in what they do own.

Seven of the 10 funds on the list are growth funds, and several of them are big technology fans. Needham Aggressive Growth (NASDAQ:NEAGX - News), Needham Small Cap Growth (NASDAQ:NESGX - News), and Needham Growth (NASDAQ:NEEGX - News) all have more than half their assets in technology, with the first two having tech weightings above 70%. While some tech stocks have done well this year, the sector as a whole has been lackluster, and those big tech weightings have contributed to the Needham funds' terrible recent relative results.

On the other hand, FBR Focus (NASDAQ:FBRVX - News) and Akre Focus (NASDAQ:AKRIX - News) have also struggled recently, despite having essentially no tech exposure. (The latter fund is run by Chuck Akre, who managed FBR Focus until leaving in 2009 to start his own firm.) These funds invest in quality growth stocks with high returns on capital, and their portfolios are currently dominated by consumer cyclical and financial stocks that should do well in a periods of slow growth. That hasn't been a good place to be for most of 2011, so the funds have lagged, though FBR Focus has an excellent long-term track record.

Finally, there are the three value funds on the list, all of them concentrated contrarian funds with great long-term records. Yacktman (NASDAQ:YACKX - News) and Yacktman Focused (NASDAQ:YAFFX - News), run by father-and-son team Don and Stephen Yacktman and Jason Subotky, hold stocks the managers consider cheap, mostly (but not exclusively) profitable, high-quality ones. These funds have often gone through stretches of underperformance in the past, but they've done very well this year despite their lack of commodity exposure, thanks to diversified portfolios that are heaviest in consumer-oriented stocks.

It's a very different story for the $18 billion Fairholme (NASDAQ:FAIRX - News) fund, run by former Morningstar Domestic-Stock Fund Manager of the Year (and Fund Manager of the Decade) Bruce Berkowitz. It has consistently been one of the best-performing large-value funds over the past decade, thanks to Berkowitz's boldly contrarian style, but in 2011 it has badly lagged its peers. As Kevin McDevitt explained in this recent video report, Fairholme's terrible 2011 results have come mainly from its financial holdings, which make up 90% of the fund's equity exposure and include such recent laggards as AIG (NYSE:AIG - News). Such periods of underperformance are an inevitable hazard for concentrated funds like Fairholme, and it's surprising that Berkowitz has managed to avoid them for so long.

Avoiding commodities has generally not been a good move this year, though some funds (including the Yacktman funds and Fidelity OTC (NASDAQ:FOCPX - News)) have been able to put up topnotch returns anyway. If commodity prices continue to fall, as they've started to do (and as they did in the second half of 2008 after a similar runup), then a lack of exposure could turn into a net positive. In any case, it's not a good idea to worry too much about such short-term issues when evaluating funds; the really good ones are worth owning despite the occasional bumps in the road.

David Kathman, CFA does not own shares in any of the securities mentioned above.

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