2 Energy Funds to Keep in Reserve

There have been many parts of the stock market that have endured a proverbial roller-coaster ride in 2008. But maybe nowhere has the up and down pitch been more severe than in the energy sector. Speculators pushed oil close to $150 a barrel by July, only to watch it plummet back to near $44 in recent days. The energy companies in the S&P 500 endured a similar swing. They returned 6.8% through the first half of the year. Since then that same collection of companies is down 41.6%.

That sporadic performance has also impacted the fund world. Natural resources funds — that's the label Lipper affixes to the category — did well during the commodities run-up. Now, though, that situation has reversed course. The average mutual fund in the category has dropped 48.4% in 2008, about nine percentage points worse than a plain-vanilla index fund.

Whenever a fund category makes such exaggerated moves seemingly overnight, we feel compelled to check in and give our readers some insight into what's happening. So this week we are devoting the SmartMoney.com fund screen to the natural resources category. There are just 48 funds in this sector, making it one of the smallest universes we start with all year. We narrowed that field by searching for funds that charged low fees and had above average performance track records. Not many survived the process. Only two funds made our cut this week: Columbia Energy & Natural Resources (UMESX) and Icon Energy (ICENX).

Ordinarily, our screen is set up to pinpoint the best funds in whatever niche we are looking at from week to week. This time, though, we need to weave a cautionary tale. Some financial advisors are comfortable devoting a few percentage points of a well-diversified equity portfolio to this vast and sprawling industry, at least during normal market conditions. In its current state, though, we think energy doesn't offer a compelling investment for most mainstream investors vs. other bargains in the market.

We have several concerns. The downturn in the auto industry — and the reluctance on Capitol Hill to bankroll a bailout — means the car market will be in the dumps for some time. An economic slowdown has made financing for exploration projects harder to come by or more expensive. Rising unemployment and lower wages have pinched consumers both here in the States and across the globe, leading to curtailed demand for oil and gasoline. With prices at the pump down to less than $2 a gallon from $4, drivers might start using at least some of the difference on non-energy purchases. That makes sectors like retail and consumer discretionary more attractive heading into 2009. Companies in these sectors could provide more bang for your investment buck with less risk than energy plays.

A more alarming worry is the sheer volatility of the energy industry. There's no denying the impact of speculators on the price of oil this year. Geopolitical events also weigh heavily. "I think we are in an era of heightened volatility that is unlikely to subside any time soon," says James Shelton, chief investment officer of Kanaly Trust in Houston. "It's a treacherous market."

In addition, with the advent of a new generation of exchange-traded funds like United States Oil (USO) and iPath Dow Jones-AIG Natural Gas (GAZ), even small-time investors can invest alongside giant hedge funds in all kinds of commodities — and short them, too. This has led, in part, to a market where energy-related companies and the funds that follow them can easily rise or fall 5% or 10% in a single session. Only aggressive investors enjoy navigating that type of volatility.

What's more, research shows the sector doesn't tend to lead in downturns or recoveries, regardless of the size of the company. Recent Citigroup reports were skeptical about midcap and small-cap energy and materials plays. While the reports mentioned "energy has turned slightly attractive," they also added "neither [energy nor materials] consistently tends to outperform during recessions prior to market bottoms or during late recession rebounds."

That said, any time a market pulls back like this it does offer savvy investors a potential buying opportunity. And although Shelton thinks this is a "treacherous market," he also sees plenty of bargains, too. "I think energy stocks look pretty cheap," says Shelton, who thinks a 3% to 5% portfolio exposure is appropriate at the time. "I think the market is setting itself up for a price recovery."

There are some compelling arguments, from cheap stocks unfairly beaten down to catalysts that could get the sector back on track. Consider Chesapeake Energy (CHK), a once highflying natural-gas company before investors knocked it for carrying too much debt. Its shares have sunk to as low as a recent $11.30 after being as high as $64 in the summer. Some good mutual funds from Longleaf and Fidelity are owners. OPEC may soon announce a production cut that could spark another surge in oil prices. And as soon as the global economy gets back on track, whether with the help of billions of dollars of government stimulus plans focused on infrastructure or through a true recovery, the energy demand theme that propelled this sector the last few years will certainly make a comeback.

Even new niches of the industry are starting to emerge. President-elect Barack Obama has promised to throw his support behind green energy initiatives that could provide lucrative jobs. It's still tough to predict which companies would benefit from such a push outside the obvious candidates like solar or wind firms and when such an initiative would take hold.

Remember, though, you may not have to buy an energy mutual fund to benefit from an energy rebound. Just over 13% of every S&P 500 index fund is exposed to the energy sector through companies like Exxon Mobil (XOM) and Chevron (CVX). Lastly, any investor who is thinking about jumping into this sector has to wonder whether the mutual-fund structure is the right vehicle. Shelton thinks that if an investor doesn't have the time to do homework on individual companies, ETFs, and the trading flexibility and variety they offer, may be a better choice than an actively managed fund.

The no-load energy funds on our list were open to new money, required a minimum investment under $5,000 and charged an annual expense ratio less than 1.5%. In addition, their performance track records during the trailing three- and five-year periods put them in the top 40% of Lipper's natural resources category.