Many Reasons Not to Buy Oil

Editor's Views: Why investing in oil is never simple, how equity income funds have earned a reprieve and what fund flows tell us about investor psychology

Holly Black 24 April, 2020 | 10:39AM
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Oh the irony that in the same week the oil price collapsed, we also celebrated Earth Day – an homage to all things that are environmentally friendly and sustainable, and not a finite, carbon-intensive fuel that comes out of the ground.

If the investment rule is “Buy low, sell high” then surely the question of what to do when oil prices went negative this week should have been a no-brainer.

This whole situation took some getting your head around – the idea of paying someone to take oil off your hands? - and I learnt a fabulous new word in the process: contango.

For the uninitiated, this is the phenomenon (explained excellently here by our analyst Kenneth Lamont) whereby any gains made by a fund from the oil price rising are offset as it is forced to continually sell cheap contracts and buy more expensive ones in their place.

In this instance it’s a very real reminder of why funds that track the spot price of metals are not as simple as you might think – and often not suitable for the average investor. Investors in tracker funds are often advised to pick a “physical” version as, if all else goes wrong, at least you have the actual asset as a tangible store of value. And while that’s essentially sound advice, no investor really wants a tanker of oil dumped on their driveway because they can’t find a buyer for the stuff.

The week’s shenanigans also raise the issue of over-concentration: is a fund solely focused on the oil price really right for any portfolio? It’s an incredibly specific bet on a very volatile asset, a finite resource whose price is determined by political manoeuvres and whether a bunch of world leaders can get along.

When you compare that to some of the sustainable funds we’ve looked at during Earth Day, diverse portfolios of companies with sound balance sheets and products that make the world a better place, the question of “should I buy oil?” suddenly seems incredibly outdated.

Chasing Yield

Trade bodies are not usually known for being particularly quick to react, but the Investment Association took relatively decisive action this week in suspending the yield requirements for equity income funds.

Currently funds in the UK Equity Income sector or Global Equity Income sector must at least match the yield of the FTSE All Share or the MSCI World indices respectively. Those that can’t achieve the hurdle are booted out of the group. The rule has seen a number of high-profile income funds demoted to other sectors over the years, particularly after the financial crisis when stable dividends were often hard to come by.

This time round, the IA has lifted the requirements to allow fund managers some breathing space. Had it not acted I can only see two ways this story would have ended: either with a raft of funds ejected from the sector, possibly to the point where there were none left, or with fund managers upping the risk levels of their portfolios in a desperate bid to meet the requirements.

Remember, the way to get a higher yield is to pick a riskier company – that is not the raison d’etre of an equity income fund and could have led, at best, to some nasty surprises for investors who thought they had backed a fairly vanilla portfolio and, at worst, some serious allegations of mis-selling or failure to treat customers fairly.

While the move is undoubtedly good for the sector, though, it does little to aid the plight of investors who desperately need an income from their investments to live on.

Back on Trackers

I’ve mentioned before how much I enjoy trying to read into what the monthly flows figures tell us about what investors are thinking. With a record £8.7 billion flooding out of funds in March, perhaps it’s not hard to guess what was going through their minds last month.

But a closer look, as always, reveals more. Because the two best-selling funds in the month were FTSE trackers. While the inflows may have been lower than in recent months, it’s clear that some investors were hitting the buy button on the UK stock market.

I, too, watched in awe last month as the FTSE 100 spiralled ever lower. “It can’t possibly go below 6,000, can it?” I wondered. And then: “Oh but surely it won’t go beyond 5,000.”

Obviously, I was wrong on both counts, but I was sure our British blue-chips were worth more than the market appeared to. And, clearly, I’m not alone.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Holly Black  is Senior Editor, Morningstar.co.uk