Financial Planning

Lessons on Due Diligence From the Energy Sector

No matter the investment, it pays to do your homework.

Investors should always know what they're buying-what drives returns, what it's correlated with and how can you gauge performance. Seemingly comparable investments may differ dramatically-a complicating factor. This isn't controversial advice, but now and again it's good to have a concrete reminder of the dangers of forgoing essential research. The following case studies may help.

The first concerns Master Limited Partnerships (MLPs)-energy infrastructure-focused investment vehicles (think pipelines like this one or that one) that pay out the vast majority of their profits to shareholders. MLPs' high dividend-like payments, coupled with their perceived safety, helped them gain great popularity during oil's run-up. We discuss their risks here and here, but this article isn't about that. Instead, MLPs are here to teach us how investments often diverge from investors' expectations. Here is a Bloomberg View article about two energy infrastructure (read: MLP-centric) funds with wildly differing performance since 2013. We'll call them Fund 1 and Fund 2 for simplicity.[i] Fund 1 is up 9% since September 2013-great! Fund 2 is down 30%. Not as great. What gives? Well, they have wildly different investment objectives and approaches. In addition to some old-fashioned pipelines, Fund 2 also owns a bunch of exciting new Energy services MLPs whose earnings depend more on oil prices than mere transport MLPs. Fund 1's MLP investments, on the other hand, are your old-school, move-oil-from-here-to-there type. Now, the article notes that newfangled MLP exposure hurt Fund 2's performance, and to a certain extent it did. But no MLPs-old and boring or newfangled-escaped the downturn. How, then, did Fund 1 do so much better?

Turns out Fund 1 avoided MLPs' struggles in large part by not owning MLPs-they made up less than half its holdings. Instead, it held boring old utilities, which surged early this year, during the correction's steep swings.[ii] Fund 1 can also use leverage (which amplifies the effect of price movements) and write covered call options (a way of earning income by selling the right to buy your shares if their value rises to a certain level).[iii] We aren't opining on which approach is better-Fund 1's recent advantage could reverse at any time. We merely note the two have differences any investor must take into account. MLP funds-just like other fund categories-aren't uniform.

Neither are oil ETFs. The United States Oil Fund (USO) sounds like a great way to get exposure to United States oil, known to markets as West Texas Intermediate Crude (WTI)-yet it lags WTI oil prices in 2016 by 27 percentage points. The reason lies in a subtle but crucial wrinkle in the fund's strategy: It tracks oil futures, not oil prices. Futures are designed for firms that actually might make or take delivery of oil. You know, oil firms. Refiners. The cost of storing oil rises as delivery approaches, showing up in a discounted price for nearer-term futures contracts. When USO has to buy new futures contracts to replace those nearing expiration, it buys the next month out and has to pay up for added time. This is called roll cost. Hence, performance lagged spot oil prices.

Now, don't blame the fund! It tracks the security it's supposed to (monthly oil futures) with 95% accuracy. It's just that the mechanics of doing so are a huge drag. Evidence suggests retail investors may be the primary owners of USO-likely thanks to its intuitive, user-friendly name. This article rightly ponders "how many people would have stayed away if it were called the 'United States Oil Plus Crippling Roll Costs ETF,' or if it had a parental advisory warning sticker."

Sadly, funds don't come with any such stickers-the onus is on you to get informed: What companies, sectors or commodities are they supposed to (or do you think they) track? Does history show they succeed? The case studies here involve rather niche investments, but the lessons are broad: Funds vary widely in how they define and execute their mandate, as well as in the risks and costs they incur along the way. Popular so-called "balanced" funds can possess a wide range of stock/bond allocations befitting wildly different financial goals. A US Tech-focused fund could simply hold market-cap weighted portions of the S&P 500's Technology companies, or it could focus on short-dated out of the money call options on potential Tech takeover targets.[iv] You don't know unless you check!

By the same token, don't get too excited if a fund is crushing its alleged peers, like Fund 1. Maybe it's the result of great management-or maybe it's the result of a radically different (possibly riskier) structure. This is apples and oranges stuff, or in some cases, apples and cucumbers.[v]

Likewise, it's tough to evaluate a portfolio without an appropriate comparison. Indexes work best here: A US-focused fund (or manager) should be matched against a US-specific index. If your portfolio is 40% bonds, adjust your volatility and return expectations accordingly. One cannot simply compare portfolios willy-nilly without context. Now, no manager will outperform every year. A fact. And there are far more factors relevant in selecting one than short-term performance. But if and when you are sizing up returns between two options or a portfolio and benchmark, make sure you are comparing like and like.

[i] The idea for a Dr. Seuss-style children's book detailing Fund 1 and Fund 2's lovable hijinks is ours, but we're not sticklers for copyright, so feel free to give it a shot.

[ii] Utilities have mostly lagged since.

[iii] Both strategies are complicated to carry out, and they carry risks-the former by exacerbating potential losses, the latter by limiting potential gains-but overall they've certainly worked out well for Fund 1 since 2013.

[iv] If the second half of this sentence made sense to you, great! If not, that's part of the point.

[v] Cucumbers being even further removed from their doctor-deterring counterparts, you see.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.