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U.S. Natural Gas: The Portfolio Diversification Effect Explored

by Patrick Oberhaensli, on Jun 15, 2019 11:00:00 AM

What we would like to illustrate in this article is that Natural Gas, as a financial investment, can help to diversify a two-assets portfolio when a simple active strategy is applied. If a Buy-and-Hold approach is used, it won’t be adding any value. Natural Gas on the longer term (from today’s perspective) has a very negative return while its volatility is more than double that of a typical diversified equity market (in the developed regions).

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"Classic" Moderate Risk Portfolio

Let’s do some portfolio analysis with the following assumptions: a part of the costs is considered and a constant asset allocation is used while no leverage is applied. The period starts in June 2007 and continues up to the 31st of May 2019. The starting “classic” moderate risk portfolio is composed of 40% US mid-cap equities and 60% US Government bonds with a very long duration (which are the most impacted by moves in interest rates and do not contain corporate bond credit spreads). US mid-cap equities are expected to outperform large-cap equities long-term, motivating our choice even though a 12-year period isn’t considered exceedingly long-term.

The results are presented below:

NatGas Portfolio Analysis US mid-cap Equities

One can immediately note that bonds are among the best diversifiers of equities, despite the fact that their maximum drawdowns happened at rather similar times. Equities had their maximum drawdown of -54.48% in June 2008 to March 2009 while bonds had theirs during end of 2008 to June 2009 at -26.59%. In that 12-year time frame, the Sharpe Ratio of 0.77 for the combined portfolio was quite high. In other words, improving further such a portfolio by adding a new asset isn’t an easy task, but that’s exactly what we’re going to do in the following example.


Adding a New Asset

If we add 10% long-only and therefore passive US Natural Gas (with limitations not discussed here) while taking the same percentage of 5% out of equities and bonds, assuming US Natural Gas hasn’t been leveraged or optimized at any moment, we find for the same time period for the portfolio the following characteristics:

US NatGas Portfolio 10% long-only

Also note that, taking 5% out of the equities and bonds was chosen just to observe a certain impact, but often, institutional investors will include a new asset with a low weight especially when it is not diversified, at least at the beginning (of that investment).

As expected, Natural Gas’ extremely poor cumulative performance would have critically affected the return of the new portfolio, cutting the annual return in two, while moderately increasing the portfolio volatility. The latter is related to a certain diversification effect that isn't useful in this case (one typically needs a certain level of positive return for an effective diversification effect).

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Passive Short-Exposure

Given that Natural Gas is affected by major losses over the long-term, it is interesting to make comparisons with a passive short-exposure to the commodity: such an investment would have had a well positive annual return – referring to the period of 12 years. If we add 10% short-only Natural Gas while again reducing the other two allocations by 5% respectively, we would obtain following, up to the 31st of May 2019:

US NatGas 10% short-only

We observe that as a passive short Natural Gas generated substantial long-term gains, the multi-asset portfolio would have been positively impacted as well, by 185 basis points of additional return.  Of course, this depends on when one would have entered the market (the specific period effect). While the maximum drawdown and the Sharpe Ratio would have seen important improvements, the volatility decreased only marginally, it was the return that contributed “strongly”.


"Classic" Technical Analysis Approach

Let’s see what the improvements would be with the use of a combination of short Simple Moving Averages (SMAs) with some limitations also at the cost level. In this example we allow for both long and short positions at an absolute exposure level of 100% (therefore applying no leverage) – short (time) SMAs because the market is very volatile. The period considered starts again in June 2007 and continues up to the 31st of May 2019.

US NatGas Simple Moving Averages

Although it doesn't “beat” the results of a passive short investment in Natural Gas, applying a rather classic Technical Analysis approach allows for a slight enhancement of the risk and return characteristics versus the equity & bonds basic combination.


Simple But Differentiated Strategy

This scenario can be further improved with a simple risk element applied to the preceding approach referring to ranges. Related to Natural Gas’ own risk, in particular its jumps; this is a technique that we don’t detail here but that is available upon request. We consider the same time period:

US NatGas Simple Risk Element

We end up with a notable positive change in all of the mentioned measures by introducing a (still) simple but differentiated Natural Gas strategy in an equity & bonds portfolio. In this context, the use of long and short positions in Natural Gas is key– this is also true for other commodities like Oil and Gold.


Conclusion

We can see that by already using rather “classic“ (and certainly not complex) approaches to actively manage US Natural Gas, we can benefit from a useful portfolio diversification. Another significant aspect is to have a reasoning that takes account of the “visible” market characteristics of the commodity Natural Gas in an extensive way and go beyond, which we will do in the next article…


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EVOLIDS FINANCE LLC, Disclaimer:

  • This content is not intended to be a solicitation nor an offer
  • The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible
Topic:Asset AllocationInvestment StrategyNat GasDiversificationCommodities
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