Is Picking Energy Stocks a Waste of Time?
A Tale of Two Hedge Funds - Backtesting Fund strategies over different price regimes
Today we ask an age-old question whose answer remains a mystery: should I focus on stock-picking, or is my time better spent researching industry, geopolitical, and higher-level trends?
First we’ll run through a high-level example of why one strategy is certainly better than the other.
Then we’ll lay out two distinct investment strategies:
Hedge Fund A - who focuses primarily on in-depth company-level research, ultimately driving a long/short position in two energy stocks
Hedge Fund B - who has a wider lens, focusing on industry, economic, and geopolitical trends to make an investment decision in a broader ETF
Then, the two environments the backtesting will be performed under:
Environment 1 - oil tops and begins its decline
Environment 2 - oil bottoms and begins its ascension
Then we’ll conduct backtests under each environment, identify which strategies performed best under which environments, and use these findings to shape the future of our research that would lead to maximizing ROIs.
The Power of Industry Trend Analysis for Maximizing ROI
Investing based on higher-level research on industry trends will almost always yield higher ROIs
Caveats:
You enter a levered position in a long + short pair trade to capitalize on operational, geologic, managerial outperformance
You’ve solidified your long-term industry thesis and begin to screen companies that can best capitalize on it
Choosing to simply go long or short on a stock based solely on company-level research is a losing strategy when compared to investing in an ETF backed by robust industry-level analysis.
Focusing on company-level research without a solid foundation of understanding for industry trends, or without employing (levered) long/short strategies, is a poor use of time.
Example: I spend all my time researching and analyzing oil production companies.
After some filtering, I come to the conclusion that the "cheapness" of Stock A is not worth the geologic, operational, or capital allocation risk. Stock B would end up giving me a better risk/return for my investment.
We initiate a long position in Stock A.
Well, if oil ends up falling from $80 to $40/bbl then the time researching these individual stocks was spent in vain. Even the most promising oil producer stock would suffer.
But if oil goes to $100/bbl, both companies are likely to soar.
That’s why it’s essential to closely monitor the current commodity environment and anticipate potential pivots or inflection points before worrying about which stock to be exposed to.
In our backtests we compare two hedge funds.
One uses a long/short (pair trade) to strip out commodity market impacts and focus solely on the financial, geologic, operational, and managerial outperformance of one stock over another.
The other enters a simple long or short trade on a related ETF based on higher-level, multi-faceted industry trend analysis.
We will soon see how a well-researched directional bet on a related basket of stocks generates superior risk-adjusted returns compared to simply going long or short a stock.
However. Compared to an investor engaged in a pair trade, the performance results come close.
This leads us to a nuanced conclusion that helps frame the importance of dedicating more time towards adopting one strategy of another under different commodity environments.
Setting the Investment Stage
Our Investors:
Hedge Fund A - Pear Tree Partners:
Spends 80% of time researching energy companies, and 20% of time researching industry trends
Engages in long/short strategies to hedge for their uncertainty of the commodity price outlook
In other words, goes long one oil stock and short the other oil stock to capture the favorable spread of one company’s operational/financial/managerial outperformance vs the other
Hedge Fund B - Top-Down Capital:
Spends 80% of time researching industry trends, and 20% of time researching energy companies
Engages mostly in broad-base asset class investing based on his industry research
In other words, buys ETFs of particular sectors he believes will benefit most from the ongoing/coming trend – where individual stocks included in the basket are only slightly important
We will not run a scenario on a Long-only hedge fund – as their returns will always be inferior to the strategies outlined above (as mentioned earlier).
Our Environments:
Environment 1:
Oil has topped – market shows some backwardation, but the commodity ends up declining faster than the original curve anticipated
Environment 2:
Oil has bottomed – the forward curve shows some contango, but overtime the actual commodity price significantly outperforms
VISUAL
Quick note on return metrics before we begin
As a hedge fund manager, it’s important to not the returns metrics used to evaluate performance. We measure both absolute returns and risk-adjusted returns using the Sharpe Ratio.
While some funds may not prioritize risk-adjusted returns, the majority do so to avoid taking on too much volatility that could lead to various vol thresholds or circuit breakers being triggered. This is often what occurs when you hear of a pod “blowing up.”
The Sharpe Ratio will be the best metric used to evaluate performance as it considers the amount of relative risk we take on to enter trades. Since absolute returns are easier to interpret, we will also display these metrics.
It’s worth noting Hedge Funds typically use leverage ratios of 2x – 10x. We’ll explore the impact of different leverage ratios on our returns and Sharpe ratios.
Let the backtests BEGIN!