What Cracked Commodity Funds?

Inflation worries ease, leading to exodus from energy and precious metal funds.

Inflation worries ease, leading to exodus from energy and precious metal funds
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What happened to commodities investments this year? Fracking has drilled a hole in the sector, and the gold bugs have taken flight.

It was supposed to be different. This year was to be the start of the Great Rotation, where stocks started in a big rally (that happened) and bonds were due for a drastic pruning as the Federal Reserve started raising interest rates (that didn't). Those inflation hedges – energy and precious metals – were supposed to start paying off as an expanding economy and years of easy money revived inflation. Again, not yet.

Instead, stocks and bonds have both rallied to all-time highs. Commodities, everyone's favorite alternative investment a year ago, have turned into a costly alternative. They've become fodder for the financial market rally as investors dumped them at a furious rate to buy more equities and fixed income.

[Read: Should You Have Alternative Investments in Your Portfolio?]

In some ways, the commodities industry itself is behind the big energy exodus. Fracking, also known as hydraulic cracking and credited with heralding a new era of cheap American energy, gets some of the blame for the shift away from once-popular raw materials.

"Shale oil is a real game-changer," says James Russell, U.S. Bank's senior equity strategist. "If it's done right, it could make U.S. energy independent. It's the biggest thing that's happened in a long time."

While gold (which is also dropping) dominates headlines, a close look at fund flows shows that the biggest seismic shift has actually been among energy funds. In the flight from commodities this year, investors have dumped 26 percent of their gold and precious metals. But they've drained even more from energy funds, in percentage terms, drawing them down nearly 40 percent, according to fund research firm Lipper. The liquidation in the energy sector was more noteworthy because it ignored the rise of nearly 2 percent in energy fund returns, while gold's collapse followed a 37 percent drop, Lipper said.

"The big pariah has been gold, and that's the one that gets the most attention," says Tom Roseen, Lipper's director of research services. "But the proportional shift in energy funds has been much bigger. It's a smaller sector so people have not noticed." Lipper data shows that $1.2 billion has been pulled from the energy sector this year, out of a total $3.2 billion at the start of 2013.

[Read: What to Make of Falling Gold Prices.]

While they are a relatively small part of the investment allocation for U.S. investors, energy funds have a broad impact as a measure of inflation and on materials producers and oil giants, whose shares have lagged the rally. The rise in oil and gas supplies is widely expected to increase in the years ahead, not just in the United States but globally, as new drilling technology boosts energy output.

Fracking gets most of its notice in debates about its environmental impact, and its pollution threat to groundwater is a major drawback. But as a short-term economic boost, there is little to argue. Already, tens of thousands of sites are extracting natural gas and oil from deposits under shale sedimentary layers throughout the United States. The biggest impact has been on natural gas output. The U.S. has doubled its output in a decade, according to the U.S. Energy Information Administration, and jumped from the No. 8 global producer to No. 2 and became a net exporter last year. The supply of shale oil is expanding globally as new horizontal drilling and hydraulic fracturing open huge new deposits.

"The world is no longer terrified of running out of important commodities," says Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, in a recent report that forecasts falling commodity prices for decades to come. Copper, aluminum, zinc and other industrial metals have been under pressure much of the year on signs that China's growth is slowing.

How to invest for end of commodities' "supercycle." OppenheimerFunds Senior Economist Brian Levitt says, "The shale oil boom has been a great story and it's one of the reasons investors are starting to let go of the view that we are locked in a commodities 'supercycle.'"