3 Reasons XLE isn’t the Inflation Hedge you’re looking for

We’re not regular readers of the Seattle times, but when a client saw managed futures mentioned in a recent Q&A in the investing section – they pointed us to the piece…

Here’s the question that was asked…

Q: Most of our retirement is in 401(k) or Roth IRA plans managed by a large firm with a reasonable expense ratio, TIAA-CREF.

A small firm that trades in managed futures has recently contacted us. The firm’s adviser uses a trend-following algorithm to govern all trades. There is a minimum investment in the low six figures. The story looks good, the returns look good (even net of fees), and it appears to be an asset class that is not represented in our otherwise fairly diverse portfolio.

What is your opinion of trading in managed futures?”

Sounds like an intelligent investor, if we say so ourselves…. So what does Scott Burns – an MIT grad, author, and 30+ years in financial planning have to say about managed futures?

A: Managed futures accounts are really great for the managers and the brokerage operations that trade the commodity futures contracts.

They aren’t so good for you or me. The main reason is that commodities are not an earning asset, so you are really betting that your account managers will make enough speculating on price changes to overcome a 2 percent managing cost, 20 percent of any profits, and the cumulative bid/ask spread and commissions for all the trading done. Basically, you’re “playing against the house.”

If you want a big, simple protection from inflation, consider buying an exchange-traded fund that is an index of energy companies, such as the Energy Select Sector SPDR (ticker: XLE; expense ratio 0.18 percent) or Vanguard Energy (ticker: VDE; expense ratio 0.14 percent).”

Now, we hadn’t picked a fight or had to defend managed futures from the ‘different is bad’ crowd in a while in this space…(see our previous one’s here and here) but this seemed like just the thing which deserved a response. And indeed, Mike Dever of Brandywine Asset (and Jackass Investing fame) stuck up for the asset class in the comments.  But we had our own thoughts:

We’ll start with his second point – to use an index of energy companies such as XLE as a cheaper proxy for managed futures. Well, the investor didn’t say that was why they wanted managed futures exposure; but let’s assume for the sake of argument that is why they are looking at the asset class. The first thing you will see is that the XLE is way more volatile than the managed futures index, with XLE at an annualized volatility of 22% and the CTA Index at 6.8%, so roughly 3.25 times more volatile.

Monthly ReturnSource: BarclayHedge CTA Index
Disclaimer: (Past performance is not necessarily indicative of future results)

This means any meaningful comparison will need to normalize the volatility, which we did by multiplying the monthly profits and losses of the BarclayHedge CTA Index by 3.25 (easily achieved in managed futures due to notional funding).

So, if you are going to consider XLE as a choice for “big, simple protection from inflation”, how does XLE compare to the performance of managed futures during an inflationary period… such as the January 2007 – June 2008 period which saw Crude Oil rise from $61 to $133/Barrel?

XLE vs Barclay 07 08Source: BarclayHedge CTA Index
Disclaimer: (Past performance is not necessarily indicative of future results)

They were pretty even during that period, although we can’t help but notice that managed futures (at 3.25x) did outperform by a bit, and with less of a drawdown. But let’s say that is immaterial, and they are essentially the same during that period. Kudos to Mr. Burns for the recommendation, XLE is definitely easier to understand and easier to invest in than managed futures for most.

But… what happens next? What happens when you’re not in such a period? Glad you asked… just take a look at the XLE over the 8 months after that spike in oil happened:

XLE vs MF 08 09
Source: BarclayHedge CTA Index
Disclaimer: (Past performance is not necessarily indicative of future results)

Ouch! Two thirds of your money down the drain. Here’s the thing… you won’t likely know when that inflationary period has begun, or when it has ended. So while XLE may provide inflation protection, and while it may do well during a rising stock market… what about the rest of the time?  Is it worth it to take on all that volatility and downside risk for your inflation hedge? Doesn’t it make more sense to add an inflation hedge which doesn’t double up the stock market crash risk already in your portfolio?  Doesn’t it make sense to add an inflation hedge with a -.15 correlation to the stock market instead of a .63 correlation.

Here’s a look at the full performance of XLE versus managed futures at 3.25x since XLE’s inception in 1999.

99 XLE vs MF
Source: BarclayHedge CTA Index
Disclaimer: (Past performance is not necessarily indicative of future results)

Vami of XLE vs MFSource: BarclayHedge CTA Index
Disclaimer: (Past performance is not necessarily indicative of future results)

We appreciate your stance, Mr. Burns, but there’s a whole lot more to this equation than low expense ratios and something that goes up when Oil goes up. The three reasons XLE and VDE are no good as an inflation hedges are  they are 1. too volatile, 2. too correlated to stocks, and 3. too much drawdown for the return you get

In the words of Obi Wan Kenobi, move along… these are not the droids inflation hedges you are looking for.

2 comments

  1. Let’s see how well that XLE “diversification” works next time correlations go to 1. SImply moving one of your bags to the back of the boat doesn’t stop them from getting wet when the Stock boat capsizes. You need an entirely different boat/vehicle for the benefits of diversification.

    My favorite part is the statement that aligning investors interests with the manager (i.e. he/she only profits if the investors earn a return) is suboptimal to paying commissions to a broker. At least if a manager has a negative return you don’t pay incentive fees……does your broker refund commissions if you lose on recommended trades?

    Why do I have the feeling if an investor were down 40% in their account he would tell them it is only a paper loss…..

  2. Good information please send me more information.

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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