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Oil exposes sector ETF risk

Oil ETFs underscore the argument for passive products that track a broad market index rather than too narrow a sector.
Pouring oil from yellow drum

The global collapse of oil demand, “super-contango” in which the price per barrel today is far below the future price, shortage of oil storage facilities, and this week’s price plunge into negative territory of West Texas Intermediate (WTI) oil has been widely reported.

The three Hong Kong-listed oil sector ETFs from UBS, Mirae Asset and Samsung Asset Management, have unsurprisingly delivered some of the worst returns year-to-date among all equity products (chart below).

The oil price disaster highlights the risk of sector ETFs, which are narrowly focused compared to a passive product following a broader category or a diversified index.

There is a strong argument for low fee passive funds following a broader index, which tend to hold up better-than-average during a downturn. But with sector ETFs, the logic is clear – the less diversified the index, the higher the risk and vice versa. The one-year performance of the MSCI World index, for example, is –6.7%, compared with -85.82% for the Samsung S&P GSCI Crude Oil ER Futures ETF, according to FE Fundinfo data.

Sector-focused passive products also tend to have high tracking errors – the difference between portfolio and benchmark returns.

Passive products typically aim for a low tracking error, which indicates that the portfolio performance is close to benchmark performance.

But commodity sector funds − both physical commodities and equity available for sale in Hong Kong – have a median tracking error of 3.85, FSA reported earlier.

Compare that to broader equity ETFs and index funds, such as European equity, emerging markets or North America, which have the lowest tracking errors, with the median 0.12 for emerging markets, 0.06 for Europe, and 0.02 for North America.

Sector focus risk also applies to actively-managed funds. DBS and others have cautioned on investing in themes that lack diversification.

“Broad themes, such as environmental innovation, for example, are great. But I generally avoid buying one specific area as there isn’t flexibility or adaptability to change as investment opportunities evolve,” said Pierre DeGagné, Singapore-based head of fund selection.

Three oil ETFs vs broader Hang Seng Index and category 

Source: FE Fundinfo. SFC-registered universe. One-year returns in US dollars.

Part of the Mark Allen Group.