Coping with oil price volatility

Recent oil price volatility has raised concerns about managing portfolio risk, particularly when oil and Energy occupies a significant weighting on the TSX 60 and Composite -approximately 27%.

On the one hand, investors with exposure to oil and Energy can benefit from the rising oil prices driven by Emerging Markets growing consumption, but higher prices can also usher in inflation, which is particularly worrisome for retirees on fixed income.

Mark Yamada, principle of Toronto-based Pur Investing, says higher oil prices are not necessarily cause for concern because rising prices do not always mean higher volatility. Yamada manages investment portfolios according to the long term volatility trend of various assets as oppose to the assets’ historical returns. This approach, he says is a better way of forecasting because an asset’s volatility today tells you something of its volatility tomorrow whereas historical return tells you very little of the return tomorrow.

The long term standard deviation is one of the measures he uses to gauge volatility. According to Yamada, oil’s long term standard deviation from 1983 to 2010 is 40%. In light of rapid run-up in oil prices that was stoked by the geopolitical unrest in the Middle East and North Africa, he believes that many people would be surprised to learn that oil price volatility was actually in the low range between 20% to 25% standard deviation.

“We don’t care of rising oil prices at all. I mean some people are getting nervous out there. We’re not market timing this we’re just looking at the long term volatility of oil. And if it moves above 40% we’ll start to reduce our exposure to this.”

Broadening the asset mix

The days of a tidy portfolio with simply stocks and bond are over. Yamada believes that commodities should be included in an investment portfolio because it’s the best hedge for inflation moving forward.

In fact, he says a portfolio should include between 5 to 7 different assets for effective diversification.

In a client portfolio, Yamada may allocate the amount of commodities into the asset mix that maintains the client’s risk level, i.e. the standard deviation of the portfolio.

For example, a 60% equities and 40% bond portfolio with a time horizon of 10 years would have volatility of approximately 10% standard deviation – equities has 15% long term standard deviation. Within this portfolio, inclusion of commodities would require addition of assets such as bonds to offset the higher volatility of commodities and equities and to help maintain the portfolio’s total volatility level of 10%. Thereafter, maintaining the portfolio’s volatility/risk level is an on-going process as volatility in the market changes, adjustments in the portfolio should be made. The effect of this process is the downside risk of the portfolio can be maintained and forecasted.

“Characteristics of a portfolio with about 10% maybe a time horizon of 10 years what you would be looking for in 10 years is a return of all capital, plus inflation, with a 95% probability,” says Yamada. “It also means that in a 12 month period that a portfolio with a risk of 10% would have a maximum downside of -10% with a 99.863% probability. It’s not 100%, but it’s pretty good. It’s a different way of constructing a portfolio with a return floor underneath it.”

Chinas next export

Doug MacDonald, RFP, Vancouver-based Macdonald Shymko & Co. Ltd., agrees that it has become increasing important to broaden asset mix to include additional asset classes such as commodities because inflation is coming.

Macdonald says that for the next 10 years China will be exporting inflation to us because China’s once plentiful labour capacity is gradually thinning. With the disappearance of this excess capacity production costs in China increases because workers are able to demand higher wages and input price trends, such as oil and Energy will add to the total cost.

Inflation is coming, but has not quite hit us yet, says MacDonald. This is because Canada’s economy is still recovery mode so there is excess capacity, i.e. surplus labour.

To protect clients’ portfolio from inflation he focuses on the client that are at the greatest risk: the baby boomers. The younger clients are not really at risk because they have jobs that will adjust with inflation trends. However, the retirees, the group on fixed income, they will get hit the worst because they have very few options.

“First, avoid the long end of fixed income markets,” he says. “So, if in fact inflation happens, and it goes up to 5%, interest rates are going to up and that value of the bond is going to go down.”

Macdonald suggests clients stick with debt instruments with maturity of less than five years. Real return bonds are the only debt that he would consider with maturity past the five years mark.

If and when inflation comes, investors will demand higher return to offset inflation, but seeking higher return may entail higher risk and this may not be what the client is prepared to take on. Instead, Macdonald recommends assets that adjust quickly to price changes such as real estate because when prices go up, so will rent. In the stock market, he looks for companies that can deal with inflation and pass costs to consumers. These include companies such as banks, utilities and telephone companies. Typically, companies paying reasonable levels of dividends should be able to compensate for the level of inflation and increase those dividends.

But he’s weary of gold.

“Now, there’s a fallacy a lot of people think that gold adjust with inflation, I don’t think it does at all, and there’s no empirical evidence that it does in the sense of year by year or five years by five years,” he says. “There’s been time inflation has gone up very sharply and gold has gone down. I don’t think gold is a hedge for inflation.”

The ultimate threat

Macdonald believes rate hikes by Bank of Canada to curb inflation will dampen growth because inflation is coming from abroad and not from home.

“My hope would be they (The Bank of Canada) would recognize that and be prepared to allow inflation to move between the 1% and 3% band,” says MacDonald. “I think they’re going to have to accept this higher band because if they don’t, they’re going to choke the economy and this isn’t going to affect inflation, at all. And that could hurt not only retired people, but also working people.”