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Shopping For High Dividend ETFs? Beware Volatility

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com Yield-starved investors turn to high-dividend payers to squeeze out some cash flow, but how do you squeeze extra yield out of the market without blowing your risk budget? In today’s low-yield bond market, it’s no wonder income-oriented investors have looked to dividends for supplemental cash flows. In February 2011, ten-year Treasury notes were paying nearly two percentage points more than the S&P 500 dividend yield (see Chart 1). The yield premium has since plummeted and, at times, actually turned into a discount. Blue Chips Stalled The ten-year and blue-chip benchmarks are now pretty much stalled at a two percent yield, forcing many investors to cast about for better-paying opportunities. Especially enticing are high-dividend exchange-traded funds (“ETFs”), which offer cash flows nominally devoid of duration and interest rate risk. Seven have track records stretching back more than five years: The 100 stocks making up the iShares Select Dividend ETF (NYSEARCA: DVY ) are screened on the basis of dividend growth and sustainability. Utilities account for more than a third of the portfolio’s capitalization. Financials, mostly REITs, come in second. The 50-stock SPDR Dividend ETF (NYSEARCA: SDY ), which screens the S&P 1500 Composite Index for stocks with 20 years or more of consecutive dividend increases, maintains a narrower portfolio. Consequently, SDY skews heavily toward REITs. Vanguard avoids REITs entirely in its high-dividend product. The 400+ stocks populating the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) are more or less evenly weighted by sectors and tilt toward large caps. First Trust sponsors two veteran high-dividend ETFs. The larger, First Trust Value Line Dividend ETF (NYSEARCA: FVD ), is built with low-beta issues found with Value Line’s proprietary “safety rating” methodology. Not surprisingly, FVD gives over nearly a quarter of its real estate to utilities. The loose inclusion criteria of the WisdomTree High Dividend ETF (NYSEARCA: DHS ) accounts for its 900+ stock portfolio and its relatively modest sector bets. Still, financials are weighted more heavily than utilities. FVD’s stablemate, the First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ), is a 100-stock portfolio comprised of companies that have boosted their dividends over the past five years. REITs are specifically excluded. Accordingly, FDL tilts toward utilities. Rounding out the set is the PowerShares High Yield Equity Dividend Achievers Portfolio ETF (NYSEARCA: PEY ), a 50-stock portfolio of large caps selected on the basis of their ten-year dividend growth histories. Utilities figure heavily in the mix-more so, in fact, than in the other veteran funds. When interest rates sag, income-hungry investors may be tempted to chuck fixed-income exposure in favor of high-dividend funds. That’s a very risky move, however. Remember: These funds are equity products. Replacing all or part of a portfolio’s fixed-income allocation increases exposure to stock market volatility and can further concentrate risk in certain industry sectors. Choices, choices So how do you squeeze some extra yield out of the market without blowing your risk budget? The first step ought to be identifying the high-dividend funds that provide the greatest diversification. There’s a couple of ways to look at this problem. From Table 1, you can see that the First Trust FDL portfolio, in addition to offering the highest dividend yield, has the lowest r-squared and beta correlations versus the S&P 500. That makes FDL pretty different and pretty attractive. FDL, however, posts the worst Sharpe and Sortino ratios of the lot. Not a good thing. The Sharpe metric, remember, rates a fund’s risk-adjusted returns using total volatility. The Sortino ratio does the same thing but only uses downside deviation as the representation of risk. If preservation of capital is paramount, a high-dividend fund sporting the best Sharpe and Sortino ratios ought to be a top pick. That makes the PowerShares PEY fund a standout. The next problem is the allocation issue. Just how much of the high-dividend fund do you add to your portfolio? And, where do you carve out room for it? Here, a little backtesting offers clues. Suppose you’re keen on dampening risk as much as possible while keeping your commitment to a high-dividend product at 20 percent of your capital. Let’s look back at the last five years to see how PEY might have performed. Classic 60/40 Portfolio Our benchmark will be a classic “60/40” portfolio: 60 percent stocks, represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ), and 40 percent bonds, proxied by the iShares Core Aggregate Bond ETF (NYSEARCA: AGG ). Taking a 20 percent PEY carve-out from the bond side (a “60/20/20” allocation) produces a significantly higher average annual return than the benchmark but yields an inferior Sortino ratio. Splitting the PEY carve-out equally from the equity and bond sides (a “48/32/20” mix) improves both nominal and risk-adjusted returns but ticks up volatility. The sweet spot’s found by carving out a PEY allocation from the classic portfolio’s equity side (a “40/40/20” exposure). There’s a minimal impact on the portfolio’s average annual return but a significant reduction in volatility and, therefore, realized risk. Both risk ratios, especially the Sortino metric, are dramatically improved at the cost of just 10 basis points in annualized returns. High div/low vol packages Some newer high-dividend ETFs attempt to entice risk-averse investors by branding themselves as “low-volatility” portfolios. The oldest of these, launched in 2012, is the PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA: SPHD ). SPHD’s index methodology screens the S&P 500 for 50 of the blue-chip benchmark’s highest-paying and least-volatile components, tilting the portfolio heavily toward utilities, consumer staples and financials. At last look, SPHD paid out a 3.5 percent dividend. It’s no surprise that SPHD is highly correlated to its parent index. Movements in the S&P 500 explain 77 percent of SPHD’s variance. SPHD’s beta, at .76, makes the fund a middling competitor to the veteran high-dividend products. Using SPHD in a “40/40/20” portfolio pares 50 basis points off the return earned by a classic “60/40” portfolio and an equal amount from the portfolio’s volatility. The significant improvement in the portfolio’s Sortino ratio bespeaks SPHD’s defensive sector concentration. SPHD isn’t the only ETF claiming low-vol street cred. The Global X SuperDividend US ETF (NYSEARCA: DIV ) is another 50-stock portfolio that screens stocks for low volatility, but its universe includes MLPs and REITs. Thus, the fund’s high-dividend yield is north of seven percent. The fund’s equal-weighting scheme magnifies the energy and financial sectors’ influence, which perhaps explains why a portfolio including DIV has Sharpe and Sortino ratios worse than a classic “60/40” mix. As with anything, it pays to look beyond the advertising for real evidence. Volatility is relative. Investors will soon have another exchange-traded high-div/low-vol option. Legg Mason recently filed a registration statement for an ETF based on the QS Low Volatility High Dividend Index, a proprietary benchmark that culls 3,000 domestic stocks for sustainable dividends as well as low earnings and price volatility. The Legg Mason Low Volatility High Dividend ETF is expected to be listed on Nasdaq, but no ticker symbol has yet been assigned. What’s clear from this exercise is that dividends come at a cost. Each high-dividend fund is constructed differently, and each presents a unique combination of risks and rewards. The highest-yielding product may not be the best addition to your portfolio. It’s often better to accept a more modest cash flow than risk hard-earned capital.

Did GLD Just Enter A Bull Market?

Summary Both GLD and the HUI looked like they were on the verge of one big final drop, then on October 2, the U.S. nonfarm payrolls data for September was released. There are some bearish hurdles that suggest this rally might soon run out of steam. Possible rotation out of the market and into gold is one bullish aspect to consider right now. When you look at the big picture, the chart of the HUI doesn’t show a huge move over the last few months. I started to buy in big on October 2, as I anticipated a run to at least that level given what gold did that day. In June of this year, I turned very bearish on the precious metals sector, as the HUI was starting to break down. Long-term, I’m extremely bullish on gold, and this is where I plan to be invested heavily over the next several years. But the sector needed to put in a final bottom first, and four months ago it began that process. Since that time, the price action in the HUI was playing out almost exactly as I described it would. At the beginning of this month, we were set up perfectly for a final decline in October/November. And then a “curveball” came. As I said in a previous article : “Besides, I simply don’t have a crystal ball. I can’t be 100% sure where the exact bottom is at. Rarely do things in the market go EXACTLY as you expect them to. There will probably be some curveballs along the way.” So what do we make of this latest rally in the SPDR Gold Trust ETF (NYSEARCA: GLD ), as well as the strong rebound in the gold and silver stock indexes such as the HUI and XAU? Is this the start of a new bull market, or is this just one last bear market rally before the final lows are hit? Does this curveball (meaning the HUI deciding to break higher, not lower) change the outlook? Well, I’m certainly still very cautious right now, but I have moved back to neutral until we get more clarity on a few things. Both GLD and the HUI looked like they were on the verge of one big final drop, and then on October 2, the U.S. nonfarm payrolls data for September was released. The report said the U.S. economy created only 142,000 jobs in September, economists were expecting 203,000 new jobs for the month. And the data from August was revised downward to 136,000, from the first reported 173,000 figure. (Source: CNBC ) Investors interpreted this miss as further proof that the Fed would most likely hold off even longer when it came to raising rates, and gold spiked as a result. You can see the huge move in price and the massive volume that occurred just after the jobs report was released at 8:30 a.m. EST. (Source: Business Insider ) GLD has added to its gains over the last week or so, as have the precious metal companies. Many gold stocks have had strong percent increases during that time – climbing 25% or more. Hurdles To Overcome Given the rebound that has taken place this month, or maybe I should say stick save, some would argue that the lows are in. But there are some bearish hurdles that suggest this rally might soon run out of steam. These would need to be overcome before we could start to talk about a new bull market. The first hurdle is we didn’t see a capitulation type event in gold and silver, but one could make the argument that we did in the HUI. GLD had a slight downdraft in June and July, which amounted to only about a 9% decrease during those months. The HUI on the other hand, dropped 40%. Gold and silver stocks have a lot more leverage than GLD, but the massive carnage in the miners seemed to be suggesting that GLD was about to drop further. It didn’t though, instead, GLD rebounded and now it’s only down about 2.5% from where it was at the start of June. The HUI, on the other hand, is still down 21%. There is a big divergence occurring, and the gold stocks are still predicating more downside. Unless they can get back in line with the price of gold very soon, then GLD is going to decline once again. It almost feels like an incomplete bottom. Had GLD moved down a lot further, then it would be easier to say the lows are in. But that is not what has happened. Gold would need to move above $1,200, or 115 on GLD, for this rally to have some real momentum behind it. Until that happens, it’s too early to say the bear market is officially over. The short-term trend might be up, but the long-term trend isn’t yet. The second hurdle is, given that the mining stocks are down significantly for the year, they could start to be hit with tax-loss selling. The recent rebound has “painted some lipstick on these pigs,” as the losses were a lot worse just a scant 2 weeks ago. But the vast majority of these gold and silver miners are still showing hefty declines YTD. Goldcorp (NYSE: GG ) is down 21.7%; it was down 35% YTD at the beginning of this month. The rest listed below are still lower by a sizable percentage. There has been a major improvement since October 2, but as you can see the losses are still there. It’s possible that the rally continues and most of these are erased, but if it doesn’t, then tax-loss selling can feed on any stagnation or further decline in the HUI and XAU. (Source: YCharts) The third hurdle is the Fed still hasn’t waived the white flag. It delayed hiking rates, but in no way has it suggested they are completely off the table for this year – even if economic data is weak. The temper tantrum that the stock market threw in August was the main reasoning the Fed has pushed back its timing for the first rate increase. But the market is now assuming that the Fed will wait until 2016, or possibly even later, before it raises rates. I’m not convinced that is going to happen. The Fed stands to lose a lot of credibility if it doesn’t begin to increase the Fed Funds rate this year. It might come as a shock to some investors, but the Fed has been implying for the last 3 years that it would raise rates during 2015. It hasn’t deviated at all from that plan. If you look below, you will see that the latest meeting in September showed a large majority of Fed members/participants believe that policy tightening should happen in 2015. That has been a consistent message since September 2012. Imagine how it would look if all of the sudden they flipped. (Source: Federal Reserve) After the September meeting concluded, Fed Chair Janet Yellen said at the news conference that followed: “The recovery from the Great Recession has advanced sufficiently far, and domestic spending is sufficiently robust, that an argument can be made for a rise in interest rates at this time. We discussed this possibility at our meeting. However, in light of the heightened uncertainty abroad, and the slightly softer expected path of inflation, the committee judged it appropriate to wait for more evidence including some further improvement in the labor market to bolster its confidence that inflation will rise to 2 percent in the medium term.” “Now, I do not want to overplay the implications of these recent developments, which have not fundamentally altered our outlook.” “The economy has been performing well. And we expect it to continue to do so.” Yellen further made it clear that the crash in the Chinese market, as well as the severe decline here in the U.S, was the reasoning for the delay in rate hikes: “The Fed should not be responding to the ups and downs of the markets and it is certainly not our policy to do so. But when there are significant financial developments, it’s incumbent on us to ask ourselves what is causing them. And of course while we can’t know for sure, it seemed to us as though concerns about the global economic outlook were drivers of those financial developments.” “And so they have concerned us in part because they take us to the global outlook and how that will affect us.” Even though the disappointing September jobs report was released a few weeks after Yellen’s news conference, it should have no major influence on the decision of when to hike rates, as Yellen stated at the time: “As I noted earlier, it remains the case that the timing of the initial increase in the federal funds rate will depend on the committee’s assessment of the implications of incoming information for the economic outlook. To be clear, our decision will not hinge on any particular data release or on day-to-day movements in financial markets. Instead, the decision will depend on a wide range of economic and financial indicators and our assessment of their cumulative implications for actual and expected progress toward our objectives.” The Fed is looking at the big picture, not single pieces of economic news. Major declines in global stock markets are really the only thing that would probably give the Fed a good reason to pause. The economy is in decent shape, and the Fed isn’t going to wait until things look peachy either, as per Yellen: “If we waited until inflation is back to 2 (percent), and that will probably mean that unemployment had declined well below our estimates of the natural rate, and only then did we start to begin to … diminish the extraordinary degree of accommodation for monetary policy, we would likely overshoot substantially our 2-percent objective and we might be faced with then having to tighten monetary policy in a way that could be disruptive to the real economy. And I don’t think that is a desirable way to conduct monetary policy.” Even Stanley Fischer, vice chairman of the Federal Reserve, said in August that officials: “would not be able to postpone a decision until all doubts were resolved.” “When the case is overwhelming,” he said, “if you wait that long, then you’ve waited too long.” The statements from the Fed, as well as their consistent expectations over the last few years for policy tightening starting during 2015, seem to strongly suggest that we will see at least a 25 basis point move at either the October or December meeting (most likely December). Investors should recall that just two years ago, the expectation was for the Fed to announce at its September 2013 meeting that it was going to taper its bond purchases. The stock market, and in particular the bond market, started acting up in May of that year in anticipation of this major change in policy. The Fed decided to hold off at the September meeting, as it wanted to give the market a little more time to adjust. It finally started to taper in December of that year. We could see a repeat when it comes to the first rate hike, sometimes the market just needs a bit more time. So I believe that rate hikes are still on the table, and this should be clear at the conclusion of the next Fed meeting in a few weeks. If this occurs, then gold could come under pressure again. But it will be short-lived, I’m looking for a “sell the rumor, buy the news” event. One Bullish Aspect In Play If I had to point to one positive development for gold, it would be the decline we have seen in the major U.S. indices. Some readers might recall that I have always said the main competition for gold over the last several years has been the stock market, not the USD. Gold is always going to increase over time, no matter what the U.S. dollar is doing. What has taken the shine off of gold over the last few years has been the gargantuan rally in stocks. The concept of investors chasing returns is a familiar one, and with the run that the Nasdaq, S&P, and DJIA have had since 2011, it shouldn’t come as a shock that the gold market was suffering from lack of attention and investor dollars. (Source: StockCharts.com) It has been my argument that only when the market finally peaked and started to roll over, that gold would bottom out. Since this time last year, I have expressed my belief that not much in the way of gains would be seen in the stock market during 2015. In an article this past June, before the market started to collapse, I said the following: “The stock market has had an incredible run over the last 31/2 years. While they don’t ring a bell at the top of a bull market, I would say this is either close to being over or is over. That doesn’t mean we can’t keep hitting marginally higher highs during the next 6 months or so, just like we have been doing since the beginning of the year….There is always the possibility for a blow-off top to occur as well, but either way the easy money has been made and the stock market is very unappealing right now.” I was expecting a big sell-off in the stock market towards the end of this year or early 2016. Well, the time-table got pushed up, as investors started to liquidate in August. This market now officially looks broken, and I don’t believe we are going to see new highs anytime soon, especially not with the Fed looming in the background. So one could make the argument that the smart money knows the bull market in stocks is over, and it’s time to look for assets that are undervalued and have underperformed everything else since 2011-2012. The most logical place to rotate into would be the precious metals sector. Unless the stock market can have one final hurrah and stage a decent rally over the next few months, this rotation could continue, and that would put a firm bid under the price of gold. Below is a chart that I created using historical data points for the S&P, Gold, M2, and the USD. I showed this chart in a previous article a few months ago when I talked about this eventual rotation out of the stock market and back into gold. Unless you are in some type of hyperinflationary environment, when gold does well, the stock market will underperform, and vice versa. This inverse correlation was very apparent in the 1970s, and has been since that time. Keep in mind we are talking long-term trends here, as gold and the stock market can rise and fall in tandem for months at a time. But when you compare long-term performances over many years, they just don’t have their respective bull markets occurring during the same dates. As you can see, gold and the S&P continually move higher with the money supply. But gold and the S&P usually move inverse to one another and oscillate around M2, as it increases in quantity. So when the S&P is in a long-term bull market (such as from 1980-2000), gold is in a bear market, and vice versa. This will eventually reverse course again, and it could be starting now. If that is the case, then over the next few years, the gold line will start to trend above the red one, and the blue line will trend below it. Over the long-term, the direction of the USD is irrelevant. Source: Ycharts.com/author/FRED As the saying goes, “never fight the Fed.” The stock market has had an incredible run over the last several years; it’s going to take a monumental effort to keep that going if rates are about to increase. Money is rushing out of stocks a little sooner than I anticipated, and this “hot money” needs to find a home somewhere. Gold is the most logically choice. So possible rotation out of the market and into gold is one bullish aspect to consider right now. If This Is The Start, It’s Still Very Early In The Game There is a lot of anxiousness and confusion right now in the precious metal sector. Everybody wants to time this perfectly, or maybe I should say those on the sidelines that are calling for lower lows. This is a great opportunity and investors want to maximize their gains. But most that are familiar with this sector know just how volatile it can be, and they know that the gold stocks can be down 30-40% in a heart beat. Nobody wants to step in front of this train if there is even the remote possibility for more downside. The gold sector hasn’t been kind to many portfolios over the last few years. But while it would be extremely rewarding to nail the lows in gold and the precious metal stocks, it’s not necessary. The sector was massively undervalued to begin with, and still is, even considering the money that has been made since early October. When you look at the big picture, does the chart below reflect a huge move in the HUI over the last few months? No, it doesn’t, it looks like a blip on the screen. Even at 250, the index would appear to be just barely off the mat. If this is in fact the start of a new bull market, and I’m not suggesting it is yet, then it’s very early in the game. Heck, we are just at the “singing of the national anthem stage,” the game hasn’t really even begun yet. Of course the chart below also supports the bearish argument that there simply isn’t enough evidence yet to call a bottom. (Source: StockCharts.com) It’s important to keep perspective here. So if you are still on the sidelines, know that if this is the start of a new bull market, then we have a long-long way to go. If you are even paying attention to this sector right now then you are at a big advantage compared to everybody else. My Updated Plan Of Action As I mentioned at the start of this article, I have been very bearish on gold since the beginning of June. However, as I told readers in early August, I was hedging my bets. The HUI was extremely oversold at the time, and at minimum, I expected some sort of rebound. I wasn’t convinced that the lows in August were the final lows, but if they were then I would at least have a decent size build-up of precious metal shares. It was a very low risk opportunity at the time given the incredible pricing of the gold and silver stocks, and I felt that it was imperative to take advantage of it. I didn’t jump all in, but I did establish many positions. The plan since then has been to get in heavily, if the HUI breaks above 130; that was the key level to be taken out for me to get a lot more constructive in the short term. But I started to buy in big on October 2, as I anticipated a run to at least that level given what gold did that day. I’m not acquiring these stocks on the notion that the bear market is officially over, rather I always just follow major support and resistance (as well as my gut). It has allowed me to avoid losing money in this sector, and is the reason I’m up for 2015 even though the precious metal complex is showing losses – sizable ones for many of the stocks. I’m now neutral on the sector, given the recent gains. I’m going to hold for a bit and see what happens. I have some good profits so I don’t think I’m taking a big risk. Should this short-term move peter out, then I will look to book some of those. The real tests still lie ahead, until those are passed, we can’t label this a bull market yet. For now, let’s see how this rally plays out and what the Fed says at the conclusion of its October meeting.

How To Pick The Best Oil ETF

Summary Over the last 10 years, the number of oil ETFs has exploded with an increasing number of complex instruments available to investors to gain exposure to crude oil. Many such ETFs appear attractive to the profit-minded trader, but it is up to educated investors to determine which product is most appropriate given his/her objective, risk appetite, and timeframe. This article analyzes the most popular commodity and oil ETFs to determine which most effectively tracks the price of oil over a series of different timeframes. Commodities has arguably been the most challenging sector in which to turn a predictable profit over the past 10 years. Crude oil, the most popular commodity in the sector, has seen its price double, lose 75% of its value, double again and, most recently, drop by 50%. However, with great volatility comes great opportunity, and it is no surprise that oil prices earn front-page headlines on all major financial websites on a daily basis. For years, most small, individual traders were unable to trade crude oil. Direct trading of oil requires buying and selling of futures contracts, with one futures contract usually representing 1,000 barrels. With oil trading at an average price of $80/barrel over the past decade, a single contract would cost $80,000 — too risky for most recreational traders. Even with the necessary pocketbook, trading futures contracts is particularly dangerous in that they expire every 30 days, requiring a trader to cash out at undesirable prices or be forced to take physical delivery of the oil. That all changed in 2006 with the arrival of the United States Oil Fund (NYSEARCA: USO ), an ETF that bought and held oil futures contracts itself, and allowed traders to buy shares for under $100. Over the next 5 years, an explosion of new commodity ETF products hit the market that allowed investors myriad increasingly complex opportunities to gain direct exposure to oil. With so many products available, many investors do not understand exactly what sort of exposure they are purchasing and how closely it will actually track oil. This article does not attempt to convince you, the reader, to buy oil. Rather, it assumes that you have already made the decision to do so, and instead will discuss the most effective way to go long oil without buying futures contracts. With a market capitalization of $3.2 billion and average daily volume of 28 million shares, the United States Oil Fund is among the most the most popular commodity ETFs, and by far the most popular pure oil ETF. The ETF was launched in April of 2006 and was the first of its kind. It allocates about 75% of its holdings to oil futures contracts. Each month, it buys near-term futures contracts–which best approximate the spot price of oil–and then a week or two prior to expiration, sells them and simultaneously uses these funds to buy the next month’s contracts, thereby avoiding taking physical deliver of more than $2 billion worth of oil (or 40 million barrels) and maintaining constant exposure to the commodity. For this service, the fund charges an annual fee of around 0.7%. However, this process of buying and selling contracts is not without it complications. More on this in a moment. After witnessing the popularity of USO and its cousin the US Natural Gas Fund (NYSEARCA: UNG ), other ETF companies were quick to jump on the bandwagon with increasingly innovative and volatile products. In late 2008, ProShares upped the ante and introduced the Ultra Bloomberg Crude Oil ETF (NYSEARCA: UCO ), which utilized leverage to deliver 2x the daily movement of oil. That is, if oil (and USO) gained 2% in a day, UCO would gain 4%, and if oil lost 2%, UCO would lose 4%. Unsurprisingly, this product was embraced by daytraders due to the enhanced volatility that is their lifeblood. However, it was also traded by longer-term traders looking to capitalize on a prolonged rally in crude oil. Like clockwork, 4 years later in late 2012, the company VelocityShares decided that 2x volatility just wasn’t cutting it and released the exceptionally volatile VelocityShares 3x Long Oil ETF (NYSEARCA: UWTI ). As its name suggests, this ETF was designed to move 3x the daily price of oil. Despite their differences in leverage, all three products work similarly in that they buy futures contracts and roll them over each month, aiming to track the price of oil on a daily basis. That being said, the devil is in the details–and the interworkings of these ETFs have a lot of details that dictate whether these ETFs are effective in accurately tracking the price of oil. Let’s start simple. Figure 1 plots the price of oil versus the price of USO since its inception in April 2006. (click to enlarge) Figure 1: Crude Oil versus USO since inception in 2006, showing underperformance of ETF versus its underlying commodity Data source: Yahoo Finance; c hart created by author. Conveniently, both began the period at nearly identical prices of $68 per share or per barrel. Since then, oil has slid to $46/barrel as of September 22, 2015 while USO has slid much steeper to just $15/share. What explains this underperformance? While the previously discussed process by which USO rolls over its futures contracts each month guarantees continuous exposure to oil, it is not without its drawbacks. Were subsequent futures contracts equally priced, it would not be an issue. The fund would sell X number of soon-to-expire contracts and use these funds to buy X number of next-month contracts. However, futures contracts of commodities such as oil frequently trade in a structure known as contango where later contracts are more expensive than near contracts. This is understandable, particularly after oil has taken a large fall, that investors expect prices to rebound in the long term as uncertainty increases. Unfortunately for funds such as USO, this means that each month the fund is selling X number of contracts and buying X-Y number of contracts. Effectively, the fund is selling low and buying high. And as contango can routinely reach 1-2% per month during periods of wide contango, the fund sees a price-independent degradation of roughly this percentage. While this is relatively minor in the short term, it adds up and can be relatively devastating for long term holders, as seen in Figure 1. What about UCO and UWTI? Figure 2 below plots the performance of oil versus USO versus UCO versus UWTI since December 10, 2008. 2008 was used as it encompasses the full history of both USO and UCO. The price history of UWTI from 2008 to 2012–when it debuted–was reconstructed based on price history of USO and UCO. (click to enlarge) Figure 2: Crude Oil versus USO, UCO, and UWTI since 2008, showing massive underperformance of leveraged ETFs versus USO and crude oil Data source: Yahoo Finance; c hart created by author. If USO “underperformed,” then UCO and UWTI were decimated. UWTI dropped 99.3% from an estimated $1841 per share to just $11 per share while UCO dropped 92% despite oil squeaking out a 5% gain. This dramatic underperformance versus both oil and USO occurred for two reasons. First, the impacts of rollover discussed above are compounded due to leverage. If the monthly contango in the futures market is 2%, the attributable loss increases to 4% for UCO and 6% for UWTI, which adds up very quickly. Second, due to the leveraging process a phenomenon known as “leverage-induced decay” also weighs on performance. I will spare you all the math, but suffice to say, large moves in one direction followed by sharp reversals leads to under-performance of leveraged ETFs independent of the effects of contango. What does this mean for oil traders? Figure 3 below uses the data in Figure 1 and 2 above to calculate average, expected underperformance versus the price of oil sustained from holding USO, UCO, and UWTI over a yearlong period. Overall, 2000 different 1-year periods are used to generate this data (click to enlarge) Figure 3: Expected underperformance of USO, UCO, and UWTI based on the number of days the ETF is held, from 2008-2015 data Data source: Yahoo Finance; c hart created by author. A 22-day hold in USO is predicted to result in a 1% underperformance versus oil. That is, if oil gains 5% during this period, the ETF would be predicted to yield around 4%. On the other hand, it would take just 9 days to reach a 1% underperformance holding UCO and a mere 6 days to see a 1% underperformance holding UWTI. Over a typical year-long period, USO is expected to underperform by 10.9% compared to 22.2% for UCO and 37.4% for UWTI. It should be noted that the underperformances for UCO and especially UWTI are somewhat deceptive and in many cases may actually be much lower. For UWTI, when oil falls greater than 33.3% in a year, UWTI will inevitably “outperform” oil given that it cannot fall more than its predicted 100%, which skews the mean underperformances shown in Figure 3 to the upside. However, when sitting on an 80-90% loss, I expect any such “outpeformance” feels rather pyrrhic. Based on this analysis, it is clear that USO outperforms UCO and UWTI and comes the closest to accurately tracking the price of oil. UCO and UWTI have their uses among the day-traders and swingtraders, but should not be used as investment tools as the long-term drawdown is simply too great to justify its use. Sure, should oil double in a year, the 37% underperformance is acceptable given the predicted 300% gain, but if oil is flat on the year–which occurs much more frequently than that edge case–you are sitting on an inexcusable loss. Of the 3 ETFs, USO offers the best risk/reward profile and, in my opinion, is the superior product and the only one that should be considered for long-term investors. So far, I’ve limited this discussion to popular commodity ETFs that are designed to mimic the spot price of oil–so-called “pure oil” ETFs. As discussed, the big drawback of these products is that you CAN’T mimic the spot price of oil, not over the long term. Let’s now consider oil companies themselves. Major producing companies derive a substantial portion–if not all–of their income from oil sales. Therefore their share prices should be closely tied to the price of oil. The advantage of oil stocks over pure oil ETFs, of course, is that they are not subject to the same rollover losses as USO. If it can be determined that oil companies effectively track the price of oil on a day-to-day basis, it can be expected that they would do so over the long-term and not be subject to decay. Rather than analyze individual companies whose stocks are intermittently subject to forces not directly related to the price of oil such as earnings reports, lawsuits, and legislation, let’s instead consider a basket of oil companies to smooth out these events i.e. the oil sector ETFs. The 3 most popular oil sector ETFs are the Energy Select Sector SPDR (NYSEARCA: XLE ), the MarketVectors Oil Services ETF (NYSEARCA: OIH ), and the SPDR S&P Oil & Gas Exploration ETF (NYSEARCA: XOP ). XLE’s diverse holdings include large cap oil companies involved in all aspects of the petroleum industry such as Exxon Mobil (NYSE: XOM ), Chevron (NYSE: CVX ), and Schlumberger (NYSE: SLB ). OIH’s largest holdings, on the other hand, are more focused on oil service companies alone and include SLB, Halluburton (NYSE: HAL ), and Baker Hughes (NYSE: BHI ). Finally, XOP’s largest holdings include major exploration companies such as HollyFrontier (NYSE: HFC ), PBF Energy (NYSE: PBF ), and CVR Energy (NYSEMKT: CVR ). Figure 4 below plots the performance of each versus Oil and USO since 2009. (click to enlarge) Figure 4: Crude oil versus select oil sector ETFs Data source: Yahoo Finance; c hart created by author. Notice that the price of oil tends to form the upper bounds of this chart while USO forms the lower bounds with the 3 oil sector ETFs somewhere in between. Of the 3, XLE seems to be the best, handily outperforming both oil and USO over the 10 year period. This suggests that the oil sector ETFs are superior to USO in their ability to track oil without price-independent losses, as predicted. However, the key concept is correlation. Apple Computer (NASDAQ: AAPL ) has certainly outperformed oil and USO over the past decade as well, but given none of its businesses are related to oil, it has no correlation to the petroleum industry and is not a useful analogue. Correlation can be determined by looking at beta and the R-squared value. Figure 5 below shows a scatterplot between the daily percent change of the price of oil versus USO and XLE. (click to enlarge) Figure 5: Scatterplot comparing the daily percent performance of crude oil versus XLE and crude oil versus USO, showing a tighter correlation between oil and USO Data source: Yahoo Finance; c hart created by author. It can be easily appreciated that oil vs USO (the red dots) forms a tighter linear relationship than oil vs XLE (the blue dots), which is much more diffuse. Further, notice that the slope of the oil vs USO relationship is closer to 1:1 on the x- and y- axes while the oil vs XLE relationship is flatter. This illustrates the twin concepts of correlation and beta, respectively. Correlation is the idea that two entities are related. If entity A moves a certain magnitude, entity B moves a predictable magnitude in response. However, it does not have to be 1:1. For example, for every 10% that A moves, entity B might move 25%. Predictable, but not equal. Correlation is measured by the R-Sq value. In finance, beta is traditionally thought of as a measure of the volatility of a security or portfolio in comparison to the market as a whole. A stock with a beta of 1.0 indicates that a stock’s price movement will mimic that of the market – if the S&P 500 gains 5%, the stock will gain 5%; if the market is flat, the stock will be flat; and if the market falls 5%, the stock will fall 5%. A stock with a beta of 2 is more volatile than the market – a tech stock, for example – and will gain or lose twice that of the S&P 500 or whatever index is used as the benchmark. A beta of 0.5 is comparatively less volatile – a utilities stock, for example – and will gain or lose half of the market’s performance. While the beta is typically applied to compare a stock to a market or index it is a relatively simple calculation and can be used to compare any two equities or funds against each other. Equation 1 below shows the equation used to calculate beta: Equation 1: Beta = Covariance (Daily % Chg stock for which beta is being calculated, Daily % Chg underlying index)/Variance (Daily $ Chg Underlying index) In this case, we will be comparing the price of oil versus each of our ETFs. An ETF with a beta of 1.0 means that the ETF tracks oil on a 1:1 basis on a daily basis. Figure 6 below shows the R-Sq and beta values for USO, XLE, OIH, and XOP compared to oil. (click to enlarge) Figure 6: Betas and R-Sq values for USO, XLE, OIH, and XOP showing USO trumps the 3 oil sector ETFs by a large margin Data source: Yahoo Finance; chart created by author. Again, USO comes out on top in both categories. USO’s R-Squared with oil is 0.81, handily beating XOP which comes in second with an RSQ of 0.57 while its beta is 0.80, crushing XOP’s 0.43. Thus, while all three oil sector ETFs may outperform USO, they do so due to factors not directly related to the price of oil. This article is not about picking good investments. It is about selecting the ETF that best accomplishes a certain objective: to track the price of oil accurately over the short and long term. In conclusion, this analysis of several popular oil ETFs has determined that the United States Oil Fund is the best long-term investment in terms of accurately tracking the price of oil as well as minimizing losses due to futures contract rollover. That is not to say that the other ETFs might not have niche uses. UWTI and UCO are certainly effective trading vehicles for those trying to capitalize on an oversold bounce or socioeconomic-driven event over 3-5 days. Likewise, XOP, XLE, and OIH may be superior to USO for super-long terms investors with a Warren Buffet-like mindset who plan to hold for well-over 2 years and care more about historical performance than accuracy in tracking an underlying commodity. However, for the typical investor who is looking to capitalize on a steady rise in oil prices from a week to 2 years or so, I firmly believe the USO is the most effective trading vehicle to do so.