In the last post, I summarized the inner-workings of the Vanguard Energy Fund. Today, I’m going to take you through exactly how I would evaluate this fund as an investment opportunity for a personal investor. I’m going to pursue this evaluation under the following assumptions:
- The price of oil is fairly priced at the current date, even though short-term fluctuations will continue. There is no arbitrage opportunity that will skew the long-term performance of this fund.
- Near-term market volatility will remain high, while overall market returns will be fairly unpredictable.
- We are investing with a major aversion to risk.
These assumptions describe an environment in which we are generally unable to predict movements in stock markets without a sophisticated understanding of the markets. We must therefore assume that the markets are efficient, and pricing in correct commodity prices for the assets in question. Additionally, we must assume that fundamental macroeconomic risks will not suddenly disappear, and that we will therefore have a great deal of volatility to deal with over the near term.
Lastly, we are assuming that, as a personal investor, we are not in a position to be taking on excessive risk. With these simple criteria in mind, let me now show you how it is I would evaluate this fund as a possible addition to a personal portfolio.
When evaluating the performance of the fund, I need to take into consideration overall market conditions, as well as the fund’s overall exposure to specific volatility. Because the current markets fluctuate a great deal in response to weak volumes and company specific responses (in conjunction with macroeconomic fluctuations of course), my first instinct is to evaluate the portfolio of the company to ensure that it is well diversified. With 150 companies in the fund, Vanguard has exceeded the mathematical benchmark of diversification by five times. In addition, the global exposure provides assurance against local setbacks that might interfere with my returns.
This is as compared to the Fidelity fund, which actually maintains as much as 20% of its fund in a single company. Suddenly, the source of the discrepancy in returns becomes apparent. The fidelity fund experiences a greater volatility in returns because it has a greater company-specific exposure within its fund. Upon further investigation, it also becomes apparent that the Vanguard fund has managed to select stocks that provide a small amount of yield, therefore allowing them to present investors with small income distributions (but much greater than the distributions of the Fidelity fund).
These distributions account for another large portion of the discrepancies in the two fund’s performances, in that it secures the down-side risk of the Vanguard fund, while only slightly limiting the fund’s potential for realizing capital gains. While it may not be much, it provides a small measure of consistency if nothing else.
Having then evaluated the holdings and performance of the fund itself, I need to meet with my Investment Advisor to discuss how this fund would have an impact on my portfolio as a whole. While it would be foolish for me to give this fund a majority position of my portfolio (especially given my personal affinity for income producing assets). However, the long-term ability of this fund to perform leads me to feel as though I would like to have a respectable holding in it.
Perhaps I could fit this fund into the capital-gains and equity section of my portfolio, as being my major energy holding (this would probably be no more than a 5% amount in the overall portfolio). Not enough? Given that the fund has a yield, I could sit back and evaluate my personal willingness to be aggressive with the market, and consider the extremely small yield of the fund to be a very small portion of my fixed-income holdings.
Instead of laddering some aggressive high-yield bonds, or longer-term strip-bonds, I could consider adding an incremental position in this fund. However, I would do best to evaluate this position in truth to its application, as an income producing asset. If I am able to bear the volatility of the yield, as well as the extremely small return of the yield alone, I could possible justify this decision. Regardless, I would likely make the latter a shorter term decision, with a holding that would be cashed out over a given time period to give the appearance of income.