THE RIGHT TIME FOR MATERIALS?

The ABN AMRO Materials Fund, a Euro dollar denominated fund, invests primarily in the listed equities of companies in Europe, North America and the Far East that are engaged in the development of raw materials. The materials sector includes base metals, precious metals, bulk communities (alumina, coat, iron ore), steel, wood, paper, packaging board, construction materials and chemical products. As per the fund’s mandate, the fund invests into low-cost and well-run companies in the sector, with a focus on long-term success factors, such as financial health, cost efficiency, valuation and competitiveness of a company.

The fund has generated good returns with a cumulative return of 48.7% since the inception of the Fund in July 2004 (figures as of 31 Jan 2006, in EUR, performance based on NAV basis with dividends reinvested) .According to the portfolio manager for the fund, the fund initially underperformed in the first 14 months, as the manager “had relatively conservative views on the development of the prices of base metals and steel. The stock selection process was focused on quality mining companies with low-cost operations, and which had proven to be able to generate profits even if commodity prices would fall back.” In addition, the manager favored, and continues to favor stocks with ‘strong dividend yields’. Due to the initial run-up in commodity prices, these stocks “underperformed the benchmark as their profits suffered from higher raw materials costs”.

After a strategic review in September 2005, the manager bought into more metal stocks, with a focus on quality and valuation. Due to their focus on buying into the stocks of quality companies, the fund was able to outperform the benchmark even in the month of May , during the global equity markets correction, where metal prices took a beating as well.

Chart 1: Historical Performance of ABN AMRO Materials Fund

Source: Bloomberg & ABN AMRO Asset Management

RISING GLOBAL DEMAND

 Due to robust global demand, the prices of materials have been soaring since late last year. Companies in these sectors have benefited tremendously and have achieved historical high profits. For the emerging economies, especially China and India, the two up-and-coming economic powerhouses of the world, the rapid pace of industrialization has been the key driving force of the materials sector, and will continue to provide positive momentum for the sector for many years to come.

China and India, with a combined population of 2.3 billion inhabitants, are expected to lead the way in the consumption of these materials, which would eventually lead to a possible shortage of many materials in the near future. ABN AMRO Asset Management believes that “commodity prices are expected to stay firm” and that “the financial outlook of the existing materials producers with low-cost facilities is expected to be bright.” China relies heavily on foreign producers to satisfy her demand for many materials, as consumption levels have outstripped domestic supply levels, to support her booming economy.

As global consumption for materials increases rapidly, supply will not be able to keep pace with demand. In the past 10 years, there have been few sizable potential mine discoveries. Furthermore, the output levels’ of existing mines have been falling gradually. New mines tend to have higher capital costs and this in turn would push up metal prices.

OUTLOOK

 Prospects of higher inflation and rising interest rates have caused much volatility to commodity prices in recent weeks. This could be a sign that the commodities market is also undergoing a period of “correction”. The recent stance taken by Federal Reserve Chairman Bernanke on a possible interest rate hike have heightened the possibility of an economic slowdown in the US, which would have repercussions on the global economy. This in turn leads to a bearish outlook for the materials market as industrial consumption weakens, and demand for materials slacken.

 However, ABN AMRO Asset Management continues to be upbeat on the outlook for the materials sector in the long-term and they believe that “the general outlook for materials is positive, especially where supply and demand balance is tight.” Mr Jaap van der Geest, fund manager of the ABN AMRO Materials Fund, commented that “solid demand and tight supply have unleashed a spike in commodity prices, which may suffer the occasional correction, but the longer-term trend in prices for basic materials such as copper and steel is for a sustained advance.”

RISKS

 The fund focuses solely on the materials sector, with a large portion of the fund invested into Metal & Mining (50%) and Chemicals (39%) – see Chart 2. One of the main risks to investors would be the price volatility of these two sectors. Any fall in the prices of base metals and chemicals would have an adverse effect on the fund performance. This in turn, is dependent on global interest rate levels and the pace of global economic growth.

Rising interest rate levels would generally cause commodity prices to fall, as we have seen from the recent fall in commodity prices following signals from Federal Reserve Officials that another round of rate hikes was imminent. As the biggest consumers of materials are the global emerging markets in the likes of China and India, economic slowdown in these markets would have an adverse effect on the fund performance as well.

 Chart 2: Industry Overview of What the Fund Invests In

Source: ABN AMRO Asset Management, October 2005

CONCLUSION

As global consumption for materials increases rapidly, especially with the quickening pace of economic expansion in the emerging markets, the general outlook for materials remain relatively positive in the long-term.

The ABN AMRO Materials Fund can be part of the supplementary portfolio for the long term investor. That's because narrowly focused sector funds are considered high risk (with a Fundsupermart risk rating of 10; click here to view our risk rating system) and have higher volatility than bond funds or regional equity funds. Though volatile, they can also achieve very high returns, for example, rising by more than 40% in a year. That is why we encourage investors to diversify accordingly (click here to read an article on the importance of diversification).

Core & Supplementary Portfolio

Source: Fundsupermart.com

The pie chart above illustrates where regional and single country/sector funds (the dark blue portion) belong in an overall portfolio. The percentage, which should be allocated is dependent on an individual's risk profile. The diagram shows the asset allocation for a balanced investor, and may not reflect an individual's risk/return profile. (To view investment portfolios tailored for different risk profiles, click here for our Fundsupermart Recommended portfolios.)