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Three Energy Funds That Are Built to Last

If you must play the oil patch, demand a sober approach.

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Try as you might, it's been hard to avoid the specter of rising energy prices. Whether you're filling up your gas tank or paying your monthly heating bill, you're confronting the sobering reality that everyday costs aren't as cheap as they used to be.

When your costs are rising sharply, somebody else is probably making a bundle of money. In this case, it's energy firms. Here's why (in rather simplistic terms): Companies in the business of exploring, extracting, refining, and transporting oil and natural gas typically have enormous fixed costs. They can't erect oil rigs quickly or cheaply; it takes years and costs hundreds of millions of dollars. So when demand is strong--whether from higher unit volume or rising prices--energy firms are able to wring much greater profits out of their businesses, since they're spreading every new dollar of revenue over a fixed cost base. That dynamic tends to mean wider profit margins, higher returns on equity and, chances are, higher stock prices.

So with the price of a barrel of crude oil jumping nearly 30% over the course of 2004, it was no surprise that energy stocks were the top performers in the 2004 market. That, in turn, translated into plush returns for the typical natural-resources fund, which gained 27% last year.

Party Time
As we've seen time and time again, investors hate to miss a party, so they often show up late. To wit, according to data from mutual fund industry researcher Financial Research Corporation, investors pumped some $2.9 billion into natural-resources funds in February 2005. That's a big number when you consider that natural-resources funds took in $3.6 billion in all of 2004.

It didn't take too long for those new investors to get some unpleasant news. After climbing to a record high early in April 2005, oil prices hit a two-week skid, at one point dropping below $50 per barrel. Energy stocks followed suit: Global behemoth ExxonMobil (XOM) fell over 5% in the two-week span, while smaller, less diversified firms plunged 25% or more.

This Time It's Different, Or Is It?
The fact of the matter is that this kind of volatility goes with the territory in the oil patch. Consider this: The average natural-resources fund gained an annualized 17.7% from 1995 through 1997 and dropped over 25% in 1998. Similarly, the average fund in the category leapt 30% annually from the beginning of 1999 through the end of 2000, only to fall nearly 12% in 2001. And those 2001 returns might be a bit misleading: Small-cap stocks did well in 2001, so funds that specialized in small-cap energy firms that could have gotten truly hammered held up better than one might have expected.

True, history has not always repeated itself. Arguments abound that this time--amid China's insatiable demand for oil; political unrest in the Middle East, Russia, and Venezuela; and nagging questions about refining capacity--it's different. But we're generally skeptical when an area attracts "hot money," be it Internet stocks in the late 1990s or real estate funds in the past few years. Plus there are fundamental reasons--carefully outlined in this piece by director of stock analysis Pat Dorsey--that lead us to doubt that oil prices will continue the rapid, long-term ascent that many bulls have predicted.

So what this means is that while the prevailing winds might have shifted, the rules probably haven't. Yes, strong demand for crude oil and natural gas could be sharper and more prolonged than it has been in years past. And yet the firms involved in the energy sector will continue to follow a path with peaks and valleys.

To Succeed, Face Reality
Okay, so maybe you're undeterred by the prospect of a future marked by continuing volatility in the oil patch. For example, perhaps you're not so much interested in striking it rich as in partially hedging your own exposure to rising energy prices by buying stocks whose capital appreciation and dividend streams track those rising costs upward.

If you're in that camp or a similar one, there are a few guidelines we'd suggest you keep in mind. Look for funds that have endured a variety of market climates. Of those, focus on offerings that have tempered volatility while delivering above-average returns. Following below is a screen that we ran in the Morningstar Premium Fund Screener in order to put those principles into action.

And, mind you, there aren't an awful lot of funds to begin with, so the pickings will be slim.

1. "Fund Category = Specialty Natural Resources"
While the natural-resources category isn't the exclusive province of energy funds--there are a few metal and pure-commodity offerings mixed in as well--it's the surest way to surface managers that put the majority of assets to work in the oil patch.

2. "Distinct Portfolio = Yes"
Inserting this line--which we use in almost every screen--ensures that our list of results will include only one share class for each fund. This should make the list more readable.

3. "Morningstar Risk <= Average"
Here's our screen for volatility. There's any number of measures we could have used. For example, the most commonly used measure of volatility is standard deviation. But Morningstar Risk is a more flexible measure in a few respects. For one, while it considers all volatility, it places special emphasis on downside risk. In addition, since it measures a fund's volatility over the trailing three, five, and 10 years (the measure blends the results of those time periods) it avoids the distortions that can arise from focusing on narrower windows of time.

4. "10 Yr Return % Rank Category < 50"
Finally, while clamping down on risk is important, you don't want to simply get the dullest laggard of the bunch. This line ensures that your screen will reveal only funds that have ranked in the top half of the category over the trailing 10-year period.

5. "Closed to New Investments = No"
This is, after all, a list of potential investments, so you don't need to see funds that you can't buy.

As of April 21, 2005, the search yields three results. Click here to run this screen for yourself.

Just a Few Choices
Usually we'd like to see more options, but we're willing to be picky in these potentially dangerous waters.

Excelsior Energy & Natural Resources (UMESX): This fund actually has a wider mandate than many of the funds in its category. Manager Michael Hoover can invest in other natural-resources firms, such as metal and chemical companies, besides energy firms. So while that makes this fund less of a pure energy play, it also means that there's some added diversification. At present though, due to market-timing revelations involving advisor U.S. Trust, we don't recommend sending new money to the fund.

T. Rowe Price New Era (PRNEX): While nobody needs an energy fund, this fund might just be the top available option. T. Rowe Price has earned a reputation for steadiness, especially in dodgy areas like emerging markets and technology. This fund also fits that bill. Like Hoover, this fund's manager, Charlie Ober, doesn't just hold oil stocks here, and those that are here are largely integrated multinationals that have relatively low volatility. Moreover, he has a contrarian bent, which means he's more likely to be looking at out-of-favor areas rather than the hottest ones. The result over time has been solid returns and a relatively smooth ride compared with peers.

Fidelity Select Energy (FSENX): There tend to be a few pros and cons when it comes to Fidelity's sector funds. On the one hand, manager turnover (and thus slight strategy tweaks) tend to be fairly common. On the other hand, Fidelity has a big, talented analyst bench that provides stability, and the funds are comparably cheap. This fund tends to concentrate more heavily on the large, integrated oil firms, making it a less volatile but pure play on energy firms.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.