When investors look to get exposure to commodities, many choose to invest in commodities futures contracts. Last year, more than $62 billion flowed into commodity futures, according to Barclays Capital, and by the end of December, assets under management totaled $354 billion. By contrast, $7.6 billion flowed into natural resources private equity last year, while just $3.7 billion went into publicly traded natural resources stocks.

Research analysts and investment managers at RS Investments in San Francisco argue that investors would be better served by redirecting their commodities allocation to natural resources stocks. Not surprisingly, RS Investments manages $3.5 billion in natural resources equities. Their argument is that because of fundamental changes in the commodities markets over the last ten years, commodities futures have not and will not provide the portfolio diversification benefits historically attributed to commodities and that natural resources stocks are a better bet for keeping up with long-term inflation.

Investors have gravitated toward commodities in the last ten years for numerous reasons. Among the most important are portfolio diversification, inflation protection and positive long-term views on commodity prices and future returns. As the flow of funds demonstrates, when given a choice between commodities futures, public equity and private equity, investors have put their money in commodities futures.

Conventional wisdom is that natural resources stocks do not provide the diversification benefits of commodities futures. They are stocks, after all, and have a high equity market component, notes Christian Busken, director of real assets at investment consultant Fund Evaluation Group in Cincinnati. Moreover, many natural resources companies are involved in multiple lines of business and their stock introduces management risk into the commodities equation. The thinking is that commodities futures are a better "pure play."

Data indicates, however, that natural resources funds are not perfectly correlated to the broad stock market. Natural resources funds have an average R-squared (the percentage of their movements that can be explained by S&P 500 movements) of 69 versus 89 for the average domestic stock fund and 91 for the average global stock fund, according to Morningstar data. Moreover, management risk can be a positive factor. In the ten years ended December 2010, natural resources stocks far outperformed commodity indices. The MSCI World Commodity Producers Index returned a cumulative 204.5% versus 19.18% for the S&P GSCI Total Return index, according to data provided by RS Investments.

Operating leverage for producers of commodities and fundamental changes in commodities futures markets are responsible for those results, said RS Investments in a recent white paper titled, "Institutional Real Asset Strategies." These changes undercut arguments for investing in commodity futures and bolster arguments for the outperformance of natural resources stocks going forward, according to the firm.

One major change is that the correlation between commodity and equity returns has increased in the last ten years. This increased correlation is particularly problematic in down equity markets when investors need diversification most. In 2008, when the S&P 500 was down 37%, the S&P GSCI Total Return was down 46.5%. In 2001, when the S&P 500 was down 11.9%, the GSCI was down 31.9%. Natural resources stock funds were down 48.8% and 10.4%, respectively, in those two years.

"In each downturn since 1998, commodities were highly correlated with equities. When you look at the data, the assumption that commodities are more effective diversifiers than natural resources stocks is simply wrong," says Ken Settles, co-manager of the RS Global Natural Resources Fund, which has $2.6 billion in assets. The fund is down 0.13% this year versus a gain of 1.52% for the S&P 500. Over the last ten years, the fund has returned 14.69% annualized versus 2.36% for the S&P 500. 

Settles argues that rising correlations are the result of the elimination of spare capacity for many commodities, which characterized the 1970s and 1980s, and that changes in demand now influence pricing. While supply shocks can still send commodities soaring and equities reeling, commodities and equities now march to the same drummer-global economic growth.

Meanwhile, the rising marginal cost of supply-as companies dig deeper or go further afield to find natural resources-has resulted in expectations that commodity prices will rise. This has been reflected in the shape of commodities futures curves, which in the last ten years have become upward sloping. That means that futures contracts closest to expiration are priced lower than contracts further out on the curve. When investors roll from the nearest, cheaper contract to the next, more expensive contract, they lose money on the roll.