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Portfolio > ETFs > Broad Market

Energy ETFs: Time to Bottom Feed?

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Energy prices have crashed, taking energy stocks down with them. The Energy Select Sector SPDR ETF (XLE) suffered a 21.47% loss in 2015 and many analysts still see doom and gloom ahead. Is it time for financial advisors to nibble or stay away?

Research magazine visited with Jeremy Held, senior vice president and director of research at ALPS Funds Services. In addition to being a popular servicing platform for mutual funds, closed-end funds, ETFs and alternative funds, the Denver-based firm also manages a growing lineup of ALPS branded ETFs.

After posting three consecutive yearly losses, gold prices have rebounded and it’s lifted share prices in depressed mining stocks. Is this the bottom?

The gold market peaked in 2011 and since that time gold investors have experienced several mini rallies only to be disappointed as the price continued its secular downward decline. However, there are several reasons to believe that the current rally in gold may have some staying power.

For the first time in months, gold has started to react to the troubling interest rate and currency dynamics that affect a large portion of the world. Nearly a third of developed market equities are represented by countries that have adopted a negative interest rate policy (NIRP). Not only does this policy increase the potential for volatility and uncertainty for equity prices, it also signifies that gold, by comparison, is a higher-yielding asset.

Furthermore, after a multi-year bear market, gold stocks are among the least owned sector by both institutional and retail investors, providing a catalyst for further price increases as the rally in gold continues.

Gold mining companies are particularly well positioned for a recovery in the gold price due to higher operating leverage to the price of gold and an instant increase in the value of their reserves held in the ground.

Bond investors are once again in another quagmire with falling yields and less income. Are there any attractive alternatives?

As yields on traditional bonds continue to fall, several asset classes have emerged as a viable source of generating current income. It is critical for investors to recognize, however, that while many of these strategies produce a high level of income, they should be considered strictly as “income” alternatives rather than an “alternative to fixed income.” There are truly few substitutes for the volatility reducing benefits of a traditional fixed income allocation, particularly during times of equity market stress.

On the contrary, many alternative income strategies, such as MLPs, REITs and option-writing strategies have volatility and correlation that is more in line with equity markets than with bonds. As a result, these asset classes can be very effective in terms of generating income, but may be most appropriately used as a complement, rather than a replacement to a traditional bond portfolio.

When allocated properly and in conjunction with the risk tolerance of the investor, alternative income strategies can be a very effective way to replace the income previously generated by bonds without exposing the portfolio to significant risks should rates begin to rise.

Dividend cuts are the fear of every MLP investor. Are current payouts sustainable with oil prices under $50 per barrel?

MLPs are prized first and foremost for the consistency of their distributions. The most recent 18 months have tested the mettle of MLP investors, as limited access to capital and negative sentiment surrounding all segments of the energy value chain have sent MLP prices reeling. The market has punished MLP prices to nearly the same degree as exploration and oil service companies despite the fact that MLP cash flows often have very little direct exposure to commodity prices. In an environment where oil fell 75% from its peak and rig counts plummeted even more, MLPs have seen distributions actually rise.

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.


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