Wednesday, January 12, 2011

The Risks of ETFs - John Bogle's warning

A couple of months ago I had the chance to sit in on a lecture by John Bogle - the founder of the Vanguard Group and, arguably, the inventor of the Index Fund.

During his talk, he mentioned his concern with Exchange Traded Funds (ETFs), implying that they are far riskier than the average investor realizes.  This warning is particularly poignant, coming from the man whose work led to the invention of the ETF.  It is also worth discussing, as the Peak Oil Proof Portfolio is wholly comprised of ETFs.

John Bogle - Founder of the Vanguard Group

Bogle's argument against index-based ETFs, like SPY, are that they've become market behemoths - contributing to a significant portion of the investment in many companies.  The problem with this is that the investments in these companies are made not on the merits of the company, but solely due to the fact that they're part of an index.  For example, when an investor purchases shares of SPY, SPDR goes and purchases shares of each of the 500 component companies, in proportion to their market caps.  So SPDR would put a larger percentage of your money in the largest company (company #1) than in the smallest company (company #500) - but it would still invest money in every single company, regardless of how good an investment they each are fundamentally.  Because ETFs like SPY have so much market power, this "blind" investment of wealth in these companies (based solely on the fact that they are in, say, the S&P 500 index), can create a bubble enviornment where companies that are fundamentally weak continue to receive investor support simply because overall market sentiment is bullish.  Bogle argued that this can exacerbate the boom and bust cycle we've recently been seeing more and more often.

Because of this "blind indexing", a non-index regional mutual fund should theoretically outperform an indexed ETF, as the ETF blindly invests in an index for the region based on the weighted market capitalization of the companies in the index, while a regional mutual fund is steered by a fund manager into companies with the highest unrealized growth potential.  An analysis of mutual funds vs. their ETF equivalents in the Peak Oil Proof Portfolio seems to prove that this is true for country investment but not for commodity investment:
  • Countries
    • Australia - no direct mutual fund plays
    • Brazil
      • ETF: iShares MSCI Brazil Index: EWZ 
        • 1yr return: -0.70%
      • Mutual Fund: Dreyfus Brazil Equity Fund Class A: DBZ1Z 
        • 1yr return: +6.65%
    • Canada
      • ETF: iShares MSCI Canada Index: EWC
        •  1yr return: +14.08%
      • Mutual Fund: Fidelity Canada: FICDX
        • 1yr return: +16.75%
    • Norway and Scandinavia
      • ETF: Global X FTSE Nordic 30 ETF: GXF 
        • 1yr return: +16.48%
      • Mutual Fund: Fidelity Nordic: FNORX 
        • 1yr return: +19.19%
    • Russia
      • ETF: Market Vector Russia ETF Trust: RSX
        •  1yr return: +16.14%
      • Mutual Fund: JPMorgan Russia A: JRUAX
        • 1yr return: +26.03% 
      • Mutual Fund: ING Russia A: LETRX 
        • 1yr return: +25.28% 
      • Mutual Fund: Third Millennium Russia A: TMRFX
        • 1yr return: +20.30% 
  • Commodities - there are no direct plays because mutual funds hold company stocks rather than the physical commodities
    • Agriculture - no direct mutual fund plays
    • Metals
      • Gold - no direct mutual fund plays
      • Silver - no direct mutual fund plays
      • Industrial Metals - no direct mutual fund plays
  • Energy - 30%
    • Oil
      • ETF: Vanguard Energy ETF: VDE 
        • 1yr return: +14.73%
      • Mutual Fund: Fidelity Advisor Energy A: FANAX
        • 1yr return: +10.77%
    • Coal - no direct mutual fund plays
    • Renewable Energy
      • ETF: PowerShares Global Clean Energy Portfolio: PBD
        • 1yr return: -18.76%
      • Mutual Fund: Calvert Global Alternative Energy A: CGAEX
        •  1yr return: -21.82%

John Bogle's warning against ETFs seems to hold true for investing in foreign markets - the return on investment for mutual funds seems to be higher because of the freedom of the mutual fund manager to invest in higher-quality companies without having to maintain parity with an index.  The disadvantages of mutual funds, however, are numerous.  As you can see above, there aren't any mutual funds which are solely invested in Australia or coal or agriculture.  For commodities, there aren't any mutual fund equivalents of GLD or SLV.  If you invest in a gold-focused mutual fund, they will invest in mining companies rather than holding the physical metal.  ETFs tend to have lower fees and have a lower barrier to investment.  If, for example, you wanted to invest in the Nordic countries, you could buy as little as 1 share of GXF for around $20 today.  The Nordic mutual fund (FNORX), on the other hand, requires an initial investment of $2,500 with additional investments in $500 increments.  ETFs also beat mutual funds on liquidity.  ETFs trade like stocks as long as the markets are open, while mutual funds are only priced once a day and traded when the market is closed.  As I discuss in my "Profit from Peak Oil's Bumpy Plateau" post, this extra liquidity could be crucial if an oil price spike occurs and you need to quickly get all of your investments out of the market.

John Bogle's other main argument against ETFs is that they've turned index funds from long-term investment vehicles into short-term trading vehicles.  We see this today as ETFs have become some of the most widely-used investment vehicles for algorithmic trading computers.  Theoretically, this can make ETFs more susceptible to "flash crash" events, and Bogle argued that mutual funds better protect the long-term investor from such events.  However, if you look at the Vanguard 500 mutual fund (VFINX) versus the SPDR S&P 500 ETF (SPY) for the week around the May 6th 2009 flash crash, you will see that they hardly diverged at all.  Bogle's critics would argue that rather than making the markets more unstable, ETFs actually add to market stability by greatly increasing trading liquidity.

The other main argument, not made by John Bogle, but nonetheless prevalent in discussions of commodity ETFs, is that if you want to invest in commodities, like gold, you're better off holding the metal in physical bars or coins, rather than in an ETF.  These critics say that all you're buying is a "piece of paper" and not an actual physical asset.  Stories about the risks of gold investment are everywhere.  Bullion companies like the "International Gold Bullion Exchange" sold gold they never owned.  Other bullion companies such as "Goldline International" have come under investigation for potentially misleading sales tactics.  Mining companies like "Bre-X Minerals" misled investors by overestimating their gold resources.  Electronic gold companies like "E-Gold" have failed to reimburse customers after their accounts were hacked.  But while there are certainly bad apples out in the marketplace, I find the "only buying a piece of paper" argument to be specious.  When you purchase shares in GLD, SPDR goes out on to the world gold market and purchases physical metal which it then stores at HSBC's vault in London.  GLD hires the firm "Inspectorate" to regularly audit their gold holdings.  The firm performs an annual complete physical audit as well as random testing throughout the year.  Inspectorate claims to be the "world leader in commodity inspection and testing".  Of course, cynics would argue that before the Enron's collapse, Arthur Andersen was the "world leader" in corporate auditing.  So while investing in an ETF is not completely risk-free, choosing between physical gold and a gold ETF is like choosing between the risk of burglary and the risk of fraud.  The risk of fraud is arguably lower, as you can always sue the company which defrauded you.  In the case of GLD, you'd be able to sue SPDR and possibly HSBC.  SPDR owns dozens of other funds and HSBC is one of the largest banks in the world.  In the case of fraud, you'd likely have a better chance of getting your money back than in the case of a burglar breaking into your house and stealing your gold coins.  The upside of ETFs over holding physical metals is enormous.  Buying physical commodities, transporting them, holding them in a secure location and then selling them again is enormously expensive and time-consuming.  The low fees, high liquidity and (arguably) lower risk of commodity ETFs clearly win.

So what is an investor to do?  The answer is "it depends" - it depends on the risk tolerance and trading preference of the investor.  If you plan to buy and hold company stock for the long term, mutual funds may be the best "set it and forget it" plan.  If you believe that the sky is going to fall, or the government is going to seize your gold investments, or that the next market crash will trigger "bank holidays" where trading will be halted - you may very well be better off holding physical metals.  If, however, you plan on actively trading your portfolio to take advantage of changes in the market, ETFs are the best way to invest.

Monday, January 3, 2011

Profit from Peak Oil's Bumpy Plateau

As we enter the new year, it's time for everyone to come out of the woodwork and make their predictions for 2011.  In the past two weeks, there's been a cacophony of expert opinions predicting higher oil prices this coming year.  JPMorgan Chase and Bank of America Merrill Lynch both predict $100/bbl oil.  The ex-CEO of Shell predicts $5 gasoline.  These predictions are backed up on Wall Street with oil futures recently shifting from contango to backwardation - signaling tight physical supplies of oil.  Many experts are stating that we've passed the peak of world oil production at least two years ago and that 2011 could become a repeat of 2008 for oil prices as we trudge through the "Bumpy Plateau".

If the US economy maintains its brisk recovery in 2011 and the Chinese economy continues to increase its oil consumption at a record pace, the quickly-rising demand for oil will run straight into the wall of peak oil production in 2011, causing the price of oil to spike well above $100/bbl, and leading to a demand-destruction-induced double-dip recession.

The world economy can handle slow, steady increases in the price of oil, but fast spikes in the price of oil can have devastating consequences on the economy.  As I mentioned in my demand destruction post, there's a possibility that this post-peak-oil enviornment will lead to a series of oil price spikes followed by market crashes.  As these spikes and crashes hit, the world oil production swings along with the price of oil, masking the true worldwide oil peak - this is referred to as the "Bumpy Plateau".   As an investor, you should be looking to protect yourself and profit from these oil price spikes and market crashes during the bumpy plateau period.

The Peak Oil Bumpy Plateau

The way to profit from oil price spikes and market crashes during the "bumpy plateau" is as follows:
Step 1: Hold the Peak Oil Proof Portfolio now.
Step 2: "Sell High": As the oil shock "alarm bells" go off, short the market, sell your holdings, put the proceeds into crash-resistant holdings.
Step 3: "Buy Low": Use limit orders to buy the Peak Oil Proof Portfolio and high growth stocks at their lows following the market crash.


Step 1: Hold the Peak Oil Proof Portfolio now.

The Peak Oil Proof Portfolio is designed to diversify your holdings across asset classes, industries and countries that are best positioned to profit from a post-peak-oil world.

The Peak Oil Proof Portfolio has been beating the S&P500 for the past few months, showing the strength of these holdings.  This portfolio will allow you to profit from the current market and will limit the damage to your portfolio of a market crash should you fail to get the timing right.

Step 2: "Sell High": As the oil shock "alarm bells" go off, short the market, sell your holdings, and put the proceeds into crash-resistant holdings.

This is the difficult step, as it requires you to keep an eye on the market and to move quickly when an oil spike occurs.

One way to look out for a oil price spike is to analyze the current price as a ratio of the S&P500 to Oil.  In a price spike, this ratio typically goes "out of whack" as the price of oil moves much faster than the market.  As I mentioned in the demand destruction post, if the S&P500/Oil ratio goes below 12, the oil price spike is nearing the limit that the market can handle, which usually leads to a market crash.  Using a ratio of 12 is conservative, and it won't maximize your profits.  In the last two oil shocks the ratio actually dipped below 10 for a few days - so a more aggressive ratio (such as 10) can be used to try to maximize your profits if you're willing to take a bigger risk and keep an eye on the ratio minute-to-minute.

If you look at most recent oil shocks, you can see that the price peaks were signaled by sharp changes the price of oil right before the price spike caused a market crash.
  • 1990 Oil Shock:
    • Throughout July 1990, oil prices were around $20/bbl - an S&P500/Oil ratio of 15-20
    • Iraq invaded Kuwait on August 2nd; oil prices doubled to around $40/bbl over the following 2 months - an S&P500/Oil ratio of less than 10 as oil exceeded $35/bbl
    • The price spike pushed the US economy into a recession in October of 1990, causing the stock market to crash over 20% and pushing the price of oil back down to $20/bbl by the end of the year
  • 2000's Energy Crisis:
    • Starting in 2003, oil prices steadily rose from an average of $30/bbl to a top of $147/bbl in 2008.
    • Throughout most of this increase in oil prices, the change was slow enough that stock market increased along with the oil prices to keep the S&P500/Oil ratio around 15-20
    • In the early summer of 2008, the price of oil spiked and the S&P500/Oil ratio dropped below 10.  Shortly after this signal in mid-July, the oil hit an all time high of $147/bbl, the market crashed in October and the world entered the "Great Recession".
    • By the end of the year, oil prices had fallen down to $30/bbl - back to a 15-20 S&P500/Oil ratio.
In 1990, you could have shorted an oil ETF (if they had existed) at a price of $35/bbl (when the S&P500/Oil ratio dropped below 10) and then bought the ETF 3 months later at $20/bbl to cover your short, for a return of 75%.

Similarly, in 2008, you could have shorted an oil ETF at a price of $125/bbl (when the S&P500/Oil ratio dropped below 10) and then bought the ETF 6 months later at $30/bbl to cover your short, for a return of over 300%.

So once you see the S&P500/Oil ratio drop below 12, you should start selling your stocks, and putting the majority of the proceeds into stable currencies and stores of value.  Some examples of "stable" holdings are:
  • US Dollars - in your account as cash
  • Gold - GLD
  • Swiss Francs - FXF
Then, you should take some of your proceeds (as much as you're comfortable gambling with) and short the market.  Some examples of ETFs you can short are:
  • The Market - SPY
  • A Consumer Discretionary ETF - XLY
  • A Financial Stocks ETF - XLF
  • Real Estate - IYR
For your short positions, you can put in "buy to cover" limit orders to close out your positions and take profits as the market crashes.  Using a series of limit orders will allow you to gradually close out your order without having to stare at a computer screen all day.  For example, if you start shorting SPY with $15,000 while SPY is at a price of $150, you'd short 100 shares of SPY, then you'd put the following orders in:
  • Close out 20% of your holding if SPY falls 20%: Place a "buy to cover" order for a 20 shares at a limit of $120
  • Close out 40% of your holding if SPY falls 30%: Place a "buy to cover" order for a 40 shares at a limit of $105
  • Close out 40% of your holding if SPY falls 40%: Place a "buy to cover" order for a 40 shares at a limit of $90

Step 3: "Buy Low": Use limit orders to buy the Peak Oil Proof Portfolio and high growth stocks at their lows following the market crash.

In much the same way that you should use limit orders to cover your short positions as the market crashes, you should use limit orders to buy stocks at discount prices.

For example, you can use limit orders to purchase VDE, one of the ETFs I recommend in the Peak Oil Proof Portfolio, at a discount following a market crash.  If VDE's high was $120 before the crash and you want to own $60,000 of it, during the crash, you can put in some limit orders to purchase it at cheap prices:

  • Buy 20% if it falls 20%: Place a buy order for a 125 shares at a limit of $96
  • Buy 40% if it falls 30%: Place a buy order for a 285 shares at a limit of $84
  • Buy 40% if it falls 40%: Place a buy order for a 333 shares at a limit of $72
Of course these limit prices are just an example and you'll need to adjust the prices and quantities based on how much you want to invest, how how far you think the market will crash and what balance you want to strike between buying low and risking not being able to buy at all.  This should be repeated for all of the ETFs in the Peak Oil Proof Portfolio.

A market crash also gives you the opportunity to purchase some "high growth" ETFs while they're temporarily inexpensive.  Some examples of ETFs that you might want to snatch up are:
  • China Small Cap - HAO
  • India - EPI
  • Emerging Markets - EEM
  • Gulf States - GAF

With oil prices low from demand destruction, these high growth stocks could easily out-perform the Peak Oil Proof Portfolio as investors pile back in to stocks once the market begins to recover again.  These high growth stocks can be held until oil prices begin to climb again, at which point they can be sold and the proceeds can be invested into the Peak Oil Proof Portfolio, which, due to its commodity-heavy holdings, should outperform the market as oil prices reach their highs again.