ETF investors face highest risk as oil volatility batters energy funds

Extreme volatility seen in oil price movements over the past week, as the coronavirus pandemic continues to severely hamper demand for the commodity, could lead to emergency measures for hard hit energy funds, yet mass flows into oil ETFs may leave passive investors exposed to much greater risks.
WTI Crude futures dipped as far as $30 into negative territory for the first time in history early last week, largely due to reduced demand for the May contract and limited purchaser storing space, which was then followed by heavy falls in Brent Crude futures.
Prices recovered slightly later in the week, at least in part owing to renewed tensions between the White House and Iran, with Brent and WTI Crude futures trading at $21.80 and $15 per barrel (bl) respectively at time of publication.
The volatility has led to heavy losses across energy funds, which had already struggled amid historically low prices, with WTI Crude futures continuing to fall since they started the year trading at around $63.
Schroder ISF Global Energy and TB Guinness Global Energy are the worst-hit year to date, down 54.6% and 45.2% respectively according to FE fundinfo.
Of the 11 funds identified in the IA universe as explicitly "energy" funds, just four have total AUMs of more than £100m as at 22 April.
Notably, the trend of ‘sustainable' investments outperforming ‘mainstream' counterparts, which has proliferated so far in this crisis, is borne out in the energy fund performance figures, as shown in the table above.
Head of personal investing at investment platform Willis Owen Adrian Lowcock warned soon after the price falls and if price weakness persists "we may see some emergency steps introduced to prevent a rout" on energy funds "purely exposed to the sector."
ETF investors flood into oil
Despite heavy losses for energy funds, investors have piled into oil ETFs in recent weeks. Retail investors alone poured almost £2bn into European ETFs explicitly investing in oil between 1 January and 22 April 2020, according to Morningstar estimates.
Portfolio manager at Franklin Equity Group Matt Adams explained that as large flows into oil ETFs have "supported prices in recent weeks", the WTI price in particular is "disconnected from physical oil prices on the ground".
Senior analyst, manager research specialising in passive strategies at Morningstar UK, Kenneth Lamont noted that with the oil price hitting $100bl as recently as August 2014, the price dislocation is "striking", which has not gone unnoticed by ETF investors.
However, he warned: "Investors in oil ETCs should beware. Buying cheap oil using an ETC may seem tempting, but the complexities and idiosyncrasies of the crude futures markets mean that you can lose money even if oil prices rise. For most investors, this approach is best left to specialists".
Despite the current popularity of exchange traded products investing in oil at present, WisdomTree was forced to close one of its products on Wednesday (22 April), owing to "extreme adverse moves in oil futures".

It followed the world's largest oil-backed ETF, the $4bn United States Oil fund, being forced to overhaul its portfolio as sub-zero oil prices raised the possibility of unlimited losses for investors.
Portfolio manager of the Vontobel Commodity fund, which is down by 14.6% over past month, Mike Salden was among those warning that high ETF inflows amid current extreme volatility could leave investors with heavy losses.
He explained the current "super-contango", where the futures price of oil is far higher than the spot price, means that "investment in ETFs currently harbours high risks to investors who might be tempted to passively invest in oil due to ultra-low prices".
Salden added: "Losses occur when big index trackers must roll their spot exposure upon contract expiry since they are exposed to negative roll returns. Conversely, funds offering exposure to longer-dated oil offer lower volatility and more attractive roll returns."
CIO at Rathbones Julian Chillingworth noted ETFs are "not in a position to ever take physical delivery regardless of whether the capacity is full or not", and this is "exacerbated by the fact that capacity was full, so other professional oil traders could not find anywhere to put physical oil".
He warned ETF oil positions "will unwind quite dramatically" as "a lot of people will be quite badly burned in those ETF positions".
Active funds retreat to safety
While oil ETFs "are not in such a good place", active funds with more exposure to the oil majors as opposed to smaller producers should be better placed to ride out volatility for the asset class, according to managing director of FundCalibre Darius McDermott.
McDermott identified Guinness Global Energy as one fund that should weather the storm well owing to its bias towards quality names.
"BP and Shell will not go bust," he explained: "We will still need energy infrastructure. For them it is about picking the more resilient companies that can get through this - the more resilient ones."
Co-manager of Guinness Global Energy Jonathan Waghorn told Investment Week the fund, while typically a low-turnover vehicle, sold seven of its most financially-exposed portfolio companies at the beginning of March and has reduced its beta exposure to "about as low as we have ever had."
He added the fund will remain "defensively positioned" until the management team can have greater confidence that oil demand will rebound, at which point the team "has room to tilt the portfolio back to a more aggressive stance."
Similarly, portfolio manager of Ninety One's Global Energy fund, formerly the Investec Global Energy fund, Tom Nelson explained the management team have focussed on quality names, which are "best placed to generate free cashflow and return" and "most able to weather this challenging period for the energy sector."
This article was first published by Investment Week