Oppenheimer Real Asset offers a novel way to invest in commodities.

In the world of mutual funds, you can't get a purer play on commodity prices than Oppenheimer Real Asset. As its name suggests, the fund tries to profit from the fluctuation in prices of things you can see, touch and feel, such as natural gas, crude oil, metals, wheat and livestock.

But unlike most natural resource fund managers, who invest in stocks of companies involved in the production of those commodities, Kevin Baum skips the equity middleman by investing in commodity-linked derivative instruments whose prices fluctuate in line with changes in the value of their underlying "real asset." By doing so, he removes any whiff of stock market influence and makes it possible for a mutual fund, which can't invest in hard assets directly, to hitch a ride on commodity price fluctuations.

The strategy means that Oppenheimer Real Asset marches to a different beat than both natural resource equity funds and the overall stock market. "The returns of natural resource funds are swayed by everything from corporate management and governance issues to the overall direction of the stock market," says Baum. "Their correlation with the S&P 500 Index is stronger than their correlation with the prices of the commodities their portfolio companies produce. So they are really more of a hybrid stock and commodity investment than a true commodity play."

The disappointing performance of energy funds in 2002, a year when oil prices skyrocketed, illustrates Baum's point. According to Morningstar, the average natural resource fund ended 2002 about flat for the year-far better than the 2% drop for the S&P 500 Index, but still disappointing given the enormous surge in energy prices. (For more information on the recent performance of energy funds, see the article "Energy Funds Fail To Surge" in the April 2003 issue of Financial Advisor.) By contrast, Oppenheimer Real Asset Fund rose 27.4% for the year, thanks to its heavy exposure to the energy sector, and a strategy that allows it to profit directly from rising energy prices.

Despite the unique ultra-low stock market correlation of pure commodity plays, the mutual fund industry seems to be keeping its distance from them. Only one other mutual fund, PIMCO Commodity Real Return Strategy, focuses on commodity-linked derivatives rather than stocks. That fund, launched in June 2002, is much younger than six-year-old Real Asset.

But to the 32-year-old Baum, commodities represent both an active, vibrant market and a way of life. Growing up in Texas, he became familiar with those markets through his family's oil and gas production and livestock businesses. After graduating with a degree in finance from Texas Tech, he joined Oppenheimer in 1993 and has been a trader for Real Asset since 1997. He has managed the commodities side of the fund since 1999.

With the enormous price fluctuation of energy and other commodities, both Baum and the fund's shareholders have had a wild ride that makes stock market swings look tame by comparison. In 1998, its first full year of operation, the fund's net asset value plunged 44.9%. It rose 36.8% in 1999, and leaped another 44.4% in 2000. In 2001, it was off 31.4%. During the first quarter of this year, the fund rose 9 % in January and another 12 % in February, but flopped 14 % in March.

And while the fund and the corresponding commodity derivatives in which it invests in have little or no correlation to the stock market-the fund has a beta of just .03-they do not move in the opposite direction each and every year. In 1999, for example, both the fund and the overall stock market turned in stellar returns. In 2001, a year in which the S&P 500 Index fell 11.8 %, the fund tumbled almost three times as much.

Real Asset's returns and gyrations depend heavily on the direction of its benchmark, the Goldman Sachs Commodity Index (GSCI), a broad barometer of commodity prices throughout the world. The weighting of each commodity within the index depends on its average production over the last previous five years, and is proportional to the amount of that commodity flowing through the world economy. Its 26 commodities include six energy products, nine metals, and 11 agricultural products.

Because long futures contracts don't require a huge cash outlay, about two-thirds of the fund's assets are invested in high-quality, short-term fixed-income securities, including mortgage-backed bonds and U.S. government securities. These investments help ensure liquidity and provide some income, but have only a minor influence on overall portfolio returns. The other one-third of the fund, invested in commodity instruments, creates a 100%, dollar-for-dollar exposure to commodities.

As of mid-April, energy products, such as heating oil and gasoline, accounted for about 66% of the dollar-weighted value of the GSCI, making it by far the most influential sector. Together, industrial and precious metals accounted for about 8.5% of the index, and agriculture and livestock products another 25%.

The fund and the GSCI usually move in the same direction because Baum keeps the five broad sector weightings fairly close to that of the index. That means the energy component plays a very strong role in the fund's overall returns. He always maintains a long position in commodities, and doesn't place bets on long-term price moves.

To add incremental value to the index, Baum tries to capitalize on what he calls "temporary price dislocations" within each sector that he expects to play out in weeks or months, rather than years. For example, if seasonal factors have made heating oil relatively more expensive than gasoline, and he expects the price of heating oil to drop in the near future, he might increase his exposure to gasoline beyond that of the index.

Despite this active subsector management, and the return added by fixed-income securities, beating the benchmark for an extended period has proven to be an elusive goal. Over the five years ending December 31, 2002, the fund had an average annual return of -.92%, compared to 4.04% for the GSCI. Annual fund operating expenses, which range from 1.27% to 2.45%, depending on share class, account for some of the shortfall.

Still, some advisors see Oppenheimer Real Asset as the most convenient and practical way to gain access to the unique diversification benefits commodity prices offer. Marjorie Fox, JD, CPA, of Rembert, D'Orazio & Fox in Falls Church, Va., began investing in the fund about five years ago after reading studies that pointed to the lack of correlation between the stock market and the fund's benchmark. The decision was particularly rewarding in 2000 and 2002, she says, when the fund defied bear-market odds in the stock market to deliver outstanding returns.

She also remembers 1998, when it underperformed the stock market by a whopping 73%. Given the nature of its strategy, she says, that was understandable. "But it also failed to beat its benchmark that year, a fact that made it "doubly difficult" for me to explain its presence to clients," she says. "I remember sweating bullets after 1998 when people asked why I continued to hang on."

Because of its volatility, Fox limits her client's positions in Real Asset to no more than 5% of a portfolio. Baum pegs an appropriate portfolio allocation at about 5% to 10%, although he points out that some studies say an allocation of as much as 20% of portfolio assets toward commodities is appropriate.

But any exposure may be too much for clients who absolutely can't stomach the gut-wrenching ups and downs of commodity prices. In those cases, Fox substitutes a somewhat more traditional, less volatile alternative, such as the T. Rowe Price New Era Fund. "I know I'm getting hybrid performance with a natural resource stock fund," she says. "But if someone just can't stomach incredible volatility, it's a worthwhile trade off."

Investors willing to close their eyes and go along for the wild ride for a small percentage of their portfolios will find the commitment worthwhile, Baum contends. Although commodity prices have risen dramatically in recent years, he believes the current environment of low inventories, a weaker dollar and budget deficits set the stage for further increases. "Commodity markets respond to supply, demand and inventories," he says. "Over the last couple of years, a curtailment of supply has driven prices up. In the future, an improving economy will help the demand side of the equation to kick in."