Energy ETFs: Time to Bottom Feed?

While MLP distributions have continued to rise, albeit at a slower rate, the environment remains challenging. Reduced access to capital and a “lower for longer” scenario in oil could signify limited growth opportunities for MLPs in the near-term. However, for income-oriented investors, MLP distributions have proven to be remarkably resilient and that they can weather the storm of low oil prices.

Bottom feeding in depressed energy stocks by respected investors like David Tepper and Warren Buffett is a sign of attractive valuations in this sector. How do you see it?

Commodity prices ultimately succumb to the elegantly simple, if not sometimes cruel, law of supply and demand. In recent years, unexpected new supply from North America, coupled with OPEC’s desire to defend market share have made the world awash in oil. This scenario is unlikely to persist in the long run as a significant number of U.S. producers are currently operating below the cost of production. Furthermore, sustained lower oil prices pose a threat for many underdeveloped oil exporting countries who rely on a much higher price to fund their massive social programs.

The Energy Information Administration (EIA) projects that supply reductions from both North America and OPEC may bring global demand and supply into balance by early to middle of 2017. Investors like Tepper and Buffett recognize that the opportunity to benefit from a recovery in oil prices may not last forever and that energy producing equities may have the most potential upside if and when prices eventually rise.

Consumer staples have delivered better relative performance versus the broader stock market. What does this tell us about the stock market’s sentiment?

All market sectors are not created equal. Certain sectors, such as technology and discretionary stocks tend to thrive in market rallies, whereas defensive sectors such as utilities, health care and consumer staples tend to outperform in times of heightened volatility. The consumer staples sector, in particular, is dominated by food, beverage and tobacco companies. These companies tend to benefit from somewhat inelastic demand whether the market is rising or falling. As the saying goes, “When the going gets tough, the tough eat, drink and smoke.” As evidence, there have been 12 recessions since World War II and in every single one — 12 for 12 — consumer staples have been the best performing sector in the S&P 500.

While most market prognosticators are not predicting a recession in the current environment, the outperformance of consumer staples clearly indicates the desire on behalf of investors to seek a safe haven in the event that the market continues to trend downward.

ALPS has several equal weighted index ETFs and the equal weighting strategy has delivered impressive results compared to traditional market cap weighting. Why?

Equal weight investing has come into vogue in recent years as investors seek a way to limit the unintended consequences that can result from market-cap weighted indices. Whether it was the overvaluation of tech stocks in 1999, banks in 2007 or the FANG stocks of 2015, market-cap weighting can produce bubbles in highly concentrated, narrow segments of the market.

Equal weight indexing seeks to minimize this issue by apportioning an equal weight to each security, thus minimizing the exposure of any single security. While equally weighting at the security level addresses the issue of single stock bubbles, it introduces an entirely different problem altogether. Apple, the largest company in the S&P 500, is 100 times greater than News Corporation, the smallest company. Assigning the same weight to Apple and News Corporation, as well as the remainder of the companies in the index, introduces a significant amount of mid-cap bias. As a result, equal weight strategies tend to have much higher volatility than traditional market cap weighted strategies.

We use an alternate approach, which borrows some of the benefits of equal weighting but applies it at the sector level. Rather than assigning an equal weight to each stock, we assign an equal weight to each sector. This approach ensures meaningful exposure to every sector of the market while limiting too much exposure to any single one. In essence, we are minimizing sector, rather than stock, bubbles, which historically have had a larger impact on investor returns.