U.S. Oil Investment: High flexibility is paramount... and gets rewarded
by Patrick Oberhaensli, on Sep 14, 2020 11:55:00 AM
Given the extreme swings in U.S. oil, it is essential for investors to consider the possibility to go short in order to catch that specific alpha (this requires a certain degree of talent). In this article, we will present a long/short directional type-of-exposure of an alternative managed futures solution. Contrary to the most common strategies, the alternative approach is not focused on trend following. But of course, the main goal is to achieve a favorable risk-adjusted return profile, as is the case for nearly all investors.
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The Negative Beta Risk-Based Approach
Using the basis of an alternative strategy, unrelated to trend following, we have established a negative beta profile. For the period starting end of January 2007 up to the 27th of May 2020, including specific costs, we see the following for the US oil long/short negative beta
With an Information Ratio (IF) of 0.66, we clearly see that an alternative solution adds significant value despite the very high volatility – a value for the IR of 0.5 is considered "good". It should be noted that a volatility measure in this context has little meaning given the non-normal distribution of the returns. That volatility can hardly be reduced in a material way in the long/short context.
Investors can also note that the best month for US oil is also the best month for US high yield when a very similar risk-based strategy is applied (we wrote about this in a previous article). This indicates that it is critical to have the right timing - or rather position- in order to realize exceptional returns over a (very) short period of time.
Sharp and Rapid Moves (up and down)
As the table above shows, oil is characterized by large and rapid moves. An alternative strategy needs to be able to capitalize on that characteristic. Ultimately, the strategy is about identifying turning points, especially if oil experiences two opposite moves in sequence. That was the case in 2008 with both an up and a down move. Of course, the opposite situation can also occur like in 1998 during the Russian crisis where oil first went down to around $10 USD. Investors need to realize that for the down moves, the possibility to go short at the appropriate size is critical. That point is not at all trivial when oil is at extremely low levels, this is due to margin requirements which can increase rather abruptly.
What is currently happening?
While it is the FED that heavily influences US high yield for example by buying the junk bond (from the BB category downwards) segment via Exchanged Traded Funds, for US oil, the strong influence comes from OPEC+.
In June 2020, OPEC+, which includes Russia, repeated another month of massive production cut. This comes as the demand for oil has decreased substantially with COVID-19. One can just imagine the effect caused by the reduction in air transportation or remember that China, the first largely affected area, is the biggest importer of oil worldwide.
Market participants can expect that oil production will remain at a reduced level for some time. The length of the period depends on the combination and strength of the fiscal and monetary stimulus, the consumer behavior (the recovery of the propensity to consume) and the sanitary situation (will there be another COVID-19 wave or not and with what effects? What about an effective vaccine?).
A long/short strategy for US oil can be pretty attractive, unlike a passive long-only investment. Investors can clearly see the diversification effect of this alternative approach, which makes it then also useful in a portfolio context. What is most often overlooked, is that despite the very high volatility of oil, the maximum drawdown is still at the level of US large cap equities when an adapted long/short strategy is used. Moreover, investors should not forget that a managed futures implementation allows traders to precisely calibrate to the exposure to their needs (in the context of a mandate).
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