What purpose (if any) does an ETF tracking the oil price have in a portfolio?

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Lauretta
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What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Lauretta »

I like to regularly have a look at the AA used by a number wealth management companies in Europe where I live. I initially did this to make sure I wasn't making any big mistake in my own DIY approach. Now I do this mainly for fun and to verify the truth of Buffett's description that money managers will regularly make some changes and fiddle a bit with the portfolio just to show their clients that they are doing something and are actively looking after their wealth.
However I've seen that one money management company has a portfolio (for a risk level of 7/10) which now allocates about 10% to an ETF tracking the oil price (and about 20% in bonds and perhaps 68% in stocks and perhaps 2% in gold).
So I was surprised about this large allocation to oil. Is there any rationale for allocating such a large portion to oil (as opposed to say all commodities)?
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ivk5
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by ivk5 »

No rationale for oil or any commodities for that matter. Lots of threads here on this.

No reason to assume they know something you don't.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Lauretta »

ivk5 wrote: Sat Mar 10, 2018 10:18 am Lots of threads here on this.
Yes I saw threads on which oil Etfs people advice to use etc; but my question was more about whether they have any use within a portfolio, and if so which one.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by nisiprius »

1) I can think of no Bogleheadish purpose. It's gambling, plain and simple.

2) Even if you talk about diversified commodities exposure, there is a fairly bad past history. A couple of studies in 2006 convinced people that commodities were great stuff in a general-purpose retirement savings portfolio, and a specific fund, PCRIX, PIMCO Commodity RealReturn Strategy Fund, was one of the funds most commonly recommended for that purpose. Commodity funds were all the rage, and Fidelity included allocations of over 10% in some of its target-date retirement funds. It didn't work out well. William J. Bernstein wrote a short Kindle book in 2012, Skating Where the Puck Was, warning about it, and his warnings seem to have been well-founded.

Blue is PCRIX, since about the time commodities funds started to become popular; USO and OIL, two oil-focused commodity ETFs, which did far worse. Note that oil prices rose continuously from June, 2009 through June, 2014 and the two oil ETFs failed to reflect those gains.

At this point, I feel that commodities in general-purpose portfolios have been pretty discredited.

Source
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3) As with inverse and leveraged ETFs, you want to be sure you've read all the fine print and really understand what the particular fund or ETF is really doing under the hood, because everyday investors have gotten swindled. They were sure oil prices were about to go up, bought oil ETFs, and then when oil prices really did go up, they didn't understand why their ETF didn't.

In 2010, BusinessWeek published an article, Amber Waves of Pain
...it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund (USO), an ETF designed to track the price of light, sweet crude. "This seems to be something good," Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn't make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell by 7.4 percent. ...Wall Street had transformed the reputation of commodities from a hyper-volatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation. People who would never think of buying a tanker of crude or a silo of wheat could now put both commodities in their 401(k)s. Suddenly everybody was a speculator.

And some were losing big. The commodity ETFs weren't living up to their hype, and the reason had to do with a word Wolf had never heard before. As he browsed the blogs, he says, "I'm seeing people talking about something called contango. Nobody would define it." Wolf called his broker and asked about contango. "I don't know what it is," he replied. He called his other broker, at Charles Schwab (SCHW). "He didn't know either," Wolf says. "He said he'd ask around." Weeks later, after Wolf educated himself, he fired his Merrill broker and pulled his money out. (Merrill and Schwab declined to comment.) By then he had lost $2,500 on USO.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by MarkBarb »

The only sensible scenario I can think of would be for someone that wants to hedge oil prices. For example, I work in the upstream oil business. I've sometimes wondered if it would make sense for me to short oil to hedge against the income loss I have associated with a drop in oil prices. I'm sure that someone in the airline industry or some other heavy oil consuming industry might want to do the opposite.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by CppCoder »

MarkBarb wrote: Sat Mar 10, 2018 12:37 pm The only sensible scenario I can think of would be for someone that wants to hedge oil prices. For example, I work in the upstream oil business. I've sometimes wondered if it would make sense for me to short oil to hedge against the income loss I have associated with a drop in oil prices. I'm sure that someone in the airline industry or some other heavy oil consuming industry might want to do the opposite.
I also work in the upstream oil business. In my company, that would get you fired as a violation of mega corp's business practices policies. Independent of the merits of the strategy, you should check what your company policy is on hedging oil prices before trying it.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by BeBH65 »

I see oil and all commodities as speculation. In itself they do not create any return.
The Investor is hoping that he can sell this to the next invester at a price which is higher then what he paid himself.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by heyyou »

What purpose (if any) does an ETF tracking the oil price have in a portfolio?
None, other than nostalgia by those who experienced the gasoline shortages of the 1970s. My index funds have enough exposure now to large oil companies that I don't need any further exposure to the primary energy source of the 20th century.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Valuethinker »

The OIL ETF turned out to track the oil price spectacularly badly.

If you can't actually store the physical commodity, the ETFs don't work well at tracking the underlying. And storage of that volume is expensive.

A gold ETF works because storing gold is not large in volume relative to value. Storage costs are relatively low.

Whereas with any other commodity, that does not work so well.

https://papers.ssrn.com/sol3/papers.cfm ... id=2645444

https://faculty.fuqua.duke.edu/~charvey ... ic_and.pdf

are the go to papers on commodity investing. The total value of financial commodities though, was less than the market cap of Apple. Hence in part why the institutional investment in same was so unhappy.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by lack_ey »

Lauretta wrote: Sat Mar 10, 2018 10:03 am However I've seen that one money management company has a portfolio (for a risk level of 7/10) which now allocates about 10% to an ETF tracking the oil price (and about 20% in bonds and perhaps 68% in stocks and perhaps 2% in gold).
Okay, as explained above, you can't allocate to oil, and even if you definitely knew that and why, it's probably still worth emphasizing the difference. You can invest in oil futures or products that track oil futures; these do not track spot price movements, though they may be the best thing available for that. Sometimes the difference can be great.
Lauretta wrote: Sat Mar 10, 2018 10:03 amSo I was surprised about this large allocation to oil. Is there any rationale for allocating such a large portion to oil (as opposed to say all commodities)?
First of all, if you weight commodities by production or economic impact, you find that energy products (read: fossil fuels, most of which is actually oil specifically) comprise over half of commodities. The US ETP GSG following the old GSCI has over 60% in energy, for reference. It used to be Goldman Sachs's commodity index, hence the letters, but S&P owns it now. So oil specifically is a pretty good proxy for that market going by that definition.

Now that you've waded through all the scare talk about contango, we should note that the futures curve in crude oil is downwards sloping currently, though not by a lot—colloquially called backwardation, though maybe not necessarily actual normal backwardation depending on what future spot price expectations are. Maybe the further-out futures are priced lower in anticipation of drops in spot price to come.

It's possible that the oil weighting is in part for tactical reasons, expecting the backwardation to provide a so-called positive roll yield for a carry return. Additionally, commodities futures have generally tended to do better in some parts of the business cycle relative to others. They've been better in late expansion (late stages of an economic cycle prior to another recession), which is where a lot of people think we are today. This makes sense; as economies overheat, demand for limited commodities could increase, all the while as inflation surges. Obviously this isn't the only possible outcome, but it's not a far-fetched idea or rationale.

More generally, long positions in commodities futures are used as an inflation hedge and potentially a low-correlation (with equities, under some/many scenarios though of course not always) source of return. You find less enthusiasm these days in these ideas after the past decade of performance, but not everyone has given up, and probably rightfully so to an extent.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Lauretta »

Thanks for the excellent explanations (as always) :happy
lack_ey wrote: Sat Mar 10, 2018 5:55 pm
Additionally, commodities futures have generally tended to do better in some parts of the business cycle relative to others. They've been better in late expansion (late stages of an economic cycle prior to another recession), which is where a lot of people think we are today. This makes sense; as economies overheat, demand for limited commodities could increase, all the while as inflation surges. Obviously this isn't the only possible outcome, but it's not a far-fetched idea or rationale.
This makes a lot of sense to explain the AA of the money manager I mentioned in the OP. About a year ago I had a conversation with him, and I remember that he spoke a lot about market cycles and Ray Dalio (who also believes that we are at a late stage in the cycle), so this is probably the explanation for his high allocation to oil (futures).
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by ivk5 »

With all the technical discussion about how to hold commodities in a portfolio, I just have to re-emphasize the point nisiprius made.

Regardless of rationale for these holdings, speculating on physical commodities, currencies, cryptocurrencies, etc is not investing, in the BH sense. These are not like shares in companies that produce earnings, or bonds that pay a coupon, etc. There is a reason you do not see them in the Three Fund Portfolio. There is not a long-term positive real expected return, though there may be short-term correlation effects of interest to some people.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Valuethinker »

ivk5 wrote: Sun Mar 11, 2018 3:30 am With all the technical discussion about how to hold commodities in a portfolio, I just have to re-emphasize the point nisiprius made.

Regardless of rationale for these holdings, speculating on physical commodities, currencies, cryptocurrencies, etc is not investing, in the BH sense. These are not like shares in companies that produce earnings, or bonds that pay a coupon, etc. There is a reason you do not see them in the Three Fund Portfolio. There is not a long-term positive real expected return, though there may be short-term correlation effects of interest to some people.
I think, following Larry Swedroe, that there's an inherent return in holding commodity futures.

There's 2 things there:

-there is a "roll return" EDIT in backwardation, arising from the futures contract at purchase being cheaper than the spot price at expiry

- there's a return from the instruments held as collateral on the contracts i.e. TIPS bonds

So it's incorrect to say there is no prospective return from holding commodity futures

However the 2 Campbell Harvey articles I link to above tell you the limits of that in practice. Once institutions started chasing these returns with substantial amounts of money, they mostly dried up.

The direct hedge is to actually hold the commodities producers. Preferably in an income trust structure (Canadian tax term): ie direct flow thru of cash flow, a la REITs. This is what investors like Yale Endowment do with their timber and other natural resources holdings.
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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by Day9 »

You hold a small amount of commodities and increase the duration of your bond portfolio and this can increase expected return and decrease risk.

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Re: What purpose (if any) does an ETF tracking the oil price have in a portfolio?

Post by staythecourse »

Lauretta wrote: Sat Mar 10, 2018 10:03 am I like to regularly have a look at the AA used by a number wealth management companies in Europe where I live. I initially did this to make sure I wasn't making any big mistake in my own DIY approach. Now I do this mainly for fun and to verify the truth of Buffett's description that money managers will regularly make some changes and fiddle a bit with the portfolio just to show their clients that they are doing something and are actively looking after their wealth.
However I've seen that one money management company has a portfolio (for a risk level of 7/10) which now allocates about 10% to an ETF tracking the oil price (and about 20% in bonds and perhaps 68% in stocks and perhaps 2% in gold).
So I was surprised about this large allocation to oil. Is there any rationale for allocating such a large portion to oil (as opposed to say all commodities)?
Not correct. There is NO ETF or mutual fund I know that tracks oil prices. There are plenty that track oil FUTURES. Since to track oil would require actually purchasing the product and storing it somewhere (like only an oil barge driving around the ocean) and then sell it when it is time that is not going to be happening anytime soon (until/ if price of oil skyrockets).

I have posted before that there should be a ETN tracking spot price of oil. I am sure it will be made when/ if oil prices rise.

To answer your overall question, spot price of oil (like most commodities) over the short term do follow inflation (no better and no worse). So not much better then rolling treasury bills. That being said oil prices do rise in extreme economic situations so it would be a great "insurance" product to have if you were looking for it for that reason. I think an ETN for spot oil prices would be excellent in a heavy equity portfolio. Unfortunately, no product exists unless you just fill up oil and start storing it. I believe Robert Schiller has a good lecture on spot price of oil being a great diversifier.

Good luck.
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