How much upside is left in natural resources?

Natural-resource funds, buoyed by the performance of oil, metals, and other basic material stocks, have been on a tear.

These specialized funds were the top-performing US sector group for the third quarter, gaining 7.2 percent, according to fund tracker Lipper. For the five years ending Sept. 30, they advanced by an average annualized rate of 31.3 percent, more than double the S&P 500 stock index's gain. In September, the funds received an additional kick from a sagging US greenback, which fell to a new low against the euro after the Federal Reserve's interest rate cuts. The Fed's action sparked an upswing in commodities and revived fears of inflation. (Commodities are viewed as an inflation hedge.)

However enticing they appear, the sector's recent high returns shouldn't be extrapolated, says Morningstar analyst Michael Herbst. "These funds have had an unusually long winning streak, and you can make a case for them on a longer-term basis. But the funds carry considerably more downside risk than diversified equity funds," he says, because commodity price declines can be swift and sudden. The standard deviation of returns (a measure of volatility) of the typical natural resources fund is more than double that of the average large-cap equity fund, according to Morningstar. "It's a bit risky to chase the performance derby now," Mr. Herbst says.

Still, fund managers say, robust economic growth in emerging markets such as Brazil and China enhances the outlook for commodity producers over the next three to five years. Demand for such basic commodities as oil, copper, and nickel is outstripping supply. The rapid industrialization of emerging economies, along with major infrastructure improvements in roads, power lines, and seaports, is "the key, long-term demand driver for basic materials of all kinds," says Fred Sturm, manager of the Ivy Global Resources Fund. Many resource producers are "struggling to increase capacity after many years of underinvestment in new mining or oil drilling projects," he says.

Even if US economic growth falters and crude oil falls below $80 a barrel, says John Segner, manager of AIM Energy fund, "oil prices should remain well above historic norms." According to International Energy Association, worldwide oil demand is close to 90 million barrels a day, a tight 98 percent of production capacity. With oil-exploration costs rising and political upheavals curbing output in parts of Africa and Latin America, production is growing more slowly than anticipated, Mr. Segner says.

You don't have to be highly bullish on commodity prices to justify investing in natural-resource companies, some fund managers say. Prices of many commodities are likely to be relatively flat or lower over the next two to four years as new ore bodies, steel plants, and other sources of supply ramp up, says Mackenzie Davis, co-­manager of the RS Global Resources fund. "Since many commodity producers spill red ink when prices decline, astute stock selection and diversification among basic material sectors is essential," he says. There are few brand franchises in commodities. "The average commodity producer doesn't create much value above the cost of capital. You really have to take a hard look at each company's fundamentals, such as capital cost structure and return on investment over a three-to-five-year cycle," he adds.

Most natural resource funds are geared toward energy suppliers, which typically account for 70 percent or more of fund assets. Their portfolios typically emphasize big integrated oil companies, many of them (including France's Total and Brazil's Petrobras) based outside the US. Nonenergy holdings include sizable stakes in producers of basic materials such as fertilizer, copper, and steel. Some funds add a sliver of precious metals as well as alternative-energy stocks.

For savvy investors who recognize that "upside volatility can work in your favor, natural-resource funds are an excellent portfolio diversifier," says financial planner Chris Neubert of Southport, Conn.-based Moneco. He thinks that investors should feel comfortable assigning 5 to 10 percent of their portfolios to natural-resources funds. Among his favorites: T. Rowe Price New Era, RS Global Natural Resources, and Excelsior Energy and Natural Resources.