There aren’t many asset classes that are more out of favour than natural resources in the current environment.
Though they had been an asset allocator’s dream in the first 10 years of this century as emerging economies delivered huge amounts of growth and the so-called commodity super-cycle was in full swing, funds that concentrate on basic materials have been among the Investment Association’s worst performers over recent times.
According to FE Analytics, the average open-ended natural resources fund is down an eye-watering 34 per cent over four years while the MSCI AC World index has delivered gains of close to 50 per cent.
Those include losses of 24.6 per cent in 2011, 5.88 per cent in 2012, 7.94 per cent in 2013, 7.72 per cent in 2014 and 1.23 per cent so far this year.
Performance of funds versus index over 4yrs
Source: FE Analytics
A number of reasons have been given for that trend such as slowing economic growth in the likes of China leading to falling commodity prices, initial oversupply and poor decision making on the part of company management teams.
The fact that China is continuing to slow and the consensual view that the US dollar will strengthen from here has meant many expect natural resource to perform poorly for some time to come. 
However Neil Gregson, manager of the JPM Natural Resources fund (which had been a real favourite with investors prior to the recent bear market), is now far more positive on his asset class than he has been in the past.
“After an unprecedented four years of negative returns, we believe we are close to, if not beyond, a bottom for the sector, with signs that a recovery is already underway,” Gregson (pictured) said.
James Sutton, who is an analyst on the fund, says there are a number of reasons for that.
“The main point is, things can’t keep falling,” Sutton said. “We’ve had four years of negative returns. That is almost unprecedented and it is important to recognise what other asset classes have done over that time as equity markets have performed phenomenally well while bond markets have performed much better than expected.”
“It is an industry that has been left feeling a lot of pain as supply has been cut across the board but that should now lead to tighter markets. Then there is investor positioning, as most are massively underweight energy and basic materials.”
“The last signal that we could be at the bottom of the market is a pick-up in M&A. As equity investors are shunning the sector, corporates are seeing attractive valuations and the Shell/BG deal is the most well-known example of that, though there are other examples further down the market cap spectrum.”
Certainly, the team at JPM has felt the full force of the negative sentiment.
JPM Natural Resources’ AUM over 3yrs
Source: FE Analytics
According to FE Analytics, the Natural Resources fund has seen substantial outflows as the now £695m portfolio had an AUM of £1.8bn less than three years ago.
Also, thanks to its preference for mid and small-caps, it has been one of the worst performing commodity focused funds since Gregson took charge in January 2012. It has lost 43.05 per cent over that time while, as a point of comparison, the MSCI AC World Commodity Producers and FTSE World Industrial Metals and Mining indices have fallen 10 and 15 per cent.
Performance of fund versus indices since Jan 2012
Source: FE Analytics
Nevertheless, Sutton firmly believes that the stream of bad news for the sector is now coming to an end.
“We are at the point of maximum pain in the industry and the point of maximum pessimism towards it, which means we are now very positive on a three to five-year view and are also cautiously optimistic on a six-month view,” Sutton said.
Of course, without sounding too cynical, it isn’t too surprising that natural resources managers believe now is a good time to buy natural resources funds. So should investors be upping their exposure to the bombed out area of the market?
Ryan Hughes, fund manager at Apollo, says that while natural resources’ funds are an area he and his team have discussed a lot over the last year, they have decided to sit on the sidelines for the time being.
“Yes, they are very cheap at the moment and that’s interesting for us as we like to own areas which have been massively out of favour,” Hughes said.
“But, and this is a big but, the situation in China is a too big an issue to make us want to take the leap. China is still the largest consumer of natural resources and as it is slowing, we still believe there is the risk of a knock-on effect for commodity prices and therefore for commodity producers.”
“We would like to see the situation in China settle and people feel more comfortable about the world before we start buying again but given it is generally a higher beta sector it leads us to be more wary.”
He added: “For the moment, we think the risks outweigh the potential rewards.”
Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees with Hughes’ assessment.
“I think what we have seen in resources is a very marked boom-bust cycle with many people buying in to the ‘super-cycle’ theory of ever increasing demand and constrained supply – including company management,” Morgan said.
“I agree some of the ingredients for recovery are there: greater discipline on the part of management, consolidation through M&A and valuations that appear cheap.”
He added: “These will serve to help underpin valuations from here but what is lacking is pricing power – mining companies are price takers not price setters, so to be genuinely bullish I think you need to take a view on underlying commodities, which with a strong US dollar is difficult at the moment.”
However, if investors are willing to take a punt on natural resources and are willing to take a long-term view, Morgan says that they could turn to the closed-ended sector.
“All said though, it [the natural resources sector] is widely unloved and a closed-ended fund could be especially interesting given the discount opportunity,” Morgan said.
Morgan’s favourite pick is the BlackRock World Mining Investment Trust which is currently trading on a 9.9 per cent discount to NAV, which is wider than its one and three-year average. The trust has been headed-up by Evy Hambro since May 2010.
Performance of fund versus sector and index since May 2010
Source: FE Analytics
As the graph above shows, it is narrowly outperforming its Euromoney Global Mining benchmark over that time. That outperformance had been far greater though, but has fallen far more in line with that of the index thanks to a turbulent autumn last year following two investments in London Mining going sour.
Nevertheless, in his most recent note to investors Hambro explained why he was positive over the future.
“While the sector continues to face headwinds, it is important to remember that we are another year further into the underinvestment phase and closer to the deficit markets that we foresee,” Hambro said.
“We expect an inflection point to be reached once price (and consequently return) expectations start to recover as a result of the supply curtailment, which should accelerate with the current commodity price weakness.”
The trust, which holds 42.6 per cent in diversified commodities companies, 23.3 per cent in base metals and 13.4 per cent in gold, has gearing of 12 per cent and a dividend yield of close to 7 per cent – which reflects the out of favour nature of the asset class.
Its ongoing charges are 1.4 per cent.
