Tactical Energy: Low volatility has held back portfolio

The Tactical Energy portfolio posted a 1.6% gain during the month of April. Its benchmark, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), advanced 8%, while the S&P 500 was up 0.7% over the same period.

In the crude oil market, the June 2014 futures contract dropped $1.08 over the course of the month, settling at $99.44. In contrast, natural gas prices climbed significantly during April, with the June 2014 futures contract moving up more than 9 percent. Significant concern about low inventory levels after a cold winter powered the rally.

From its inception date of May 29, 2013, through April 30, 2014, the Tactical Energy portfolio has achieved an 11.4 % return, versus a 26.6% return for its benchmark (XOP), and a 16.4% return for the S&P 500.

However, in my opinion the daily volatility incurred by the Tactical Energy portfolio has been less than half that of its benchmark and its risk-adjusted returns through April have been comparable.

The S&P Oil & Gas Exploration and Production ETF mirrors the performance of the S&P Oil & Gas Exploration & Production Select Industry Index, an equal-weighted index currently comprised of 81 holdings.

The bulk of its holdings are companies engaged exclusively in oil and gas exploration and production. However, there is also some exposure to large, integrated companies such as Exxon Mobil (XOM), Chevron (CVX), and Conoco (COP), as well as to refiners, including Valero (VLO) and Tesoro (TSO).

The Tactical Energy portfolio attempts to deliver a risk-adjusted return that is better than what maintaining a fixed position in the E&P sector would gain by dynamically weighting exposure to the sector in accordance with what our analysis determines is its likelihood to generate positive returns.

I have now way of knowing this for sure, but I believe the strategy underpinning the Tactical Energy portfolio is meant to be effective across a full market cycle, with outperformance during bear markets more than offsetting underperformance during bull markets.

Given this, we are not surprised that the Tactical Energy portfolio has underperformed its benchmark during an 11 month span where the benchmark gained almost 27 percent. However, the magnitude of difference does surprise us, and we attribute it primarily to the lack of volatility among stocks in the E&P sector.

During the eleven full calendar months that Covestor has been tracking the performance of the Tactical Energy Portfolio, the daily volatility of XOP has measured 1.27%.  In contrast, through almost 7 years of trading history prior to that, the daily volatility of XOP averaged 2.60%.

Prior to the inception of the Tactical Energy Portfolio on Covestor, XOP experienced its lowest average daily volatility during December 2010: it was 0.89% during that month. Since the inception of the Tactical Energy Portfolio on Covestor, there have already been three calendar months with lower daily volatility, including September 2013, when it was only .66%.

Our strategy greatly benefits from market volatility, which offers rebalancing opportunities. The absence of volatility has limited our ability to rebalance, and consequently to generate a risk-adjusted returns that are better than our benchmark. We have no way of knowing this for sure, but we remain confident that when more typical levels of market volatility return to the E&P sector, our strategy will shine.

DISCLAIMER: The investments discussed are held in client accounts as of April 30, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.