In November 2010, the Fed viewed the economy as still-sluggish and announced plans to purchase an additional $600 billion in long-term Treasuries through June 2011, while also reinvesting the dollars of maturing mortgage-backed securities into Treasuries, shares Michael Souers, a Standard & Poor’s equity analyst

This program is set to expand the Fed's balance sheet by up to an additional $900 billion, he adds.

The Federal Reserve is attempting to stimulate the economy, and the plan has worked by this measure, with real GDP growth expected to rise 2.9% in 2010, according to S&P Economics.

“While this stimulative action has yet to flow through to the government's reported measure of inflation, the consumer price index (CPI), the drag on CPI is largely caused by the weak housing market (leading to a drop in owners' equivalent rent),” wrote Souers in a report released on Jan. 18.

Other costs, including food, education, health care and energy have risen, he says, with some climbing at a rapid clip. “In fact, after Bernanke's August 2010 speech in which he hinted at additional quantitative easing, commodity prices surged around the globe,” explained Souers.

The Thomson/Reuters/Jefferies CRB Index of 19 raw materials rose 17% in 2010, and hit a 27-month high earlier last week, he points out. In addition, global food prices set a new record in December, surpassing a previous high set in June 2008.

Will commodity prices continue to rise in 2011?

S&P Equity Research is forecasting gold prices to rise 13% in 2011 to $1,600, from 2010's close of $1,421/oz., according to Souers. “In addition, we see the average 2011 oil price increasing 11% over the average price in 2010,” he wrote.

The Federal Reserve is widely expected to continue its loose monetary policy, and many other Central Banks worldwide – such as Japan and the ECB – are also engaging in quantitative easing in an effort to spur domestic growth and increase exports, the analyst explains. This action makes tangible assets more valuable as currencies are debased, in our view.

“If that weren't enough to drive commodity prices higher, we think the supply/demand characteristics of most commodities are extremely favorable given the rapid industrialization of China and India, increasing worldwide population, a surge in the middle classes of many emerging market countries, and tight (and, in some cases, declining) supplies of many of the world's commodities,” Souers added.

“In addition, we see continued global economic growth increasing inflationary expectations, which would likely become a self-fulfilling prophecy to higher prices,” he wrote.

As a result, S&P's Investment Policy Committee currently suggests an Overweight recommendation to the Materials sector, and while its overall recommendation on Energy is Marketweight, S&P Equity Analysts have a positive fundamental outlook on Integrated Oil & Gas, the largest of the sector's sub-industry groups.

“Given our favorable overall view on natural resources, we sought out highly ranked mutual funds that invest in energy companies, precious metals mining companies, and agricultural companies,” said Souers in his report. “Below, we highlight three that have strong risk-adjusted returns and below-average expense ratios.”

Funds in Focus

Fidelity Select Natural Resources Portfolio (FNARX) has outperformed its S&P North American natural resources sector peers over the past 1-year, 3-year and 5-year periods ended 2010, with a nearly 200 basis point outperformance over the 5-year period (9.7% vs. 8.0%), says Souers.

FNARX keeps expenses relatively low, with a net expense ratio of 0.9% (vs. 1.6% for peers), and generates a higher Sharpe Ratio (0.06 vs. 0.02). S&P Equity Analysts have Strong Buy recommendations on Exxon Mobil, the fund's largest holding as of 11/30 (latest available) and Chevron.

In addition, top-10 holdings Halliburton, Marathon Oil and Transocean Ltd., have S&P Fair Value Rankings of 5, which is the highest possible ranking and helps support the four-star fund ranking.

As is the case with most of the offerings from this mutual fund family, says S&P, T Rowe Price's New Era Fund keeps expenses extremely low despite being actively managed. In fact, PRNEX's net expense ratio of 0.7% was the lowest of the funds that met our initial search criteria, as was the fund's turnover rate (21.0% vs. 75.9% for peers).

Moreover, PRNEX has a strong record of performance, having bested peers over the past 1-year, 3-year and 5-year periods ended Dec. 31, 2010. S&P Equity Analysts have Buy recommendations on top-10 holdings Peabody Energy, Arch Coal and Canadian Natural Resources, with BTU and ACI also receiving S&P Fair Value Rankings of 5.

For investors seeking greater allocation to precious metals mining companies, Souers and S&P say that USAA's Precious Metals & Minerals Fund. “Like the aforementioned fund, it has a very low turnover rate (23.0% vs. 87.3% for FTSE Gold Mining peers), which corresponds to a lower expense ratio than peers (1.2% vs. 1.5%), he wrote.

“Perhaps more impressive, however, is the company's investment track record, which has outperformed peers by a significant margin over the past 3-year, 5-year and 10-year periods ended 2010, including a nearly 700 basis point outperformance over the 5-year period (25.7% vs. 19.1%),” Souers wrote.

“In addition, the fund's manager has been in place since 1994, which we think lends continuity to the fund's investment strategy. As one might expect from the fund's strong returns, USAGX's Sharpe Ratio is also modestly higher than peers (0.62 vs. 0.52),” he noted.

S&P Equity analysts have Buy recommendations on top-ten holdings Barrick Gold and Newmont Mining.