Sunday, 25 May 2008

Using Index Funds to Hedge Against Rising Petrol Prices

The rising price of petrol is making news here in Australia where petrol is reaching unprecedented highs of $1.60 per liter. I drive to work and to the train station to go to university. I also drive my grandma around sometimes. I fill up approximately every fortnight. I pay approximately $70 each time I fill up. Since my parents fully subsidize my food and accommodation costs, just about all my spare money goes to petrol. It is by far my biggest expense. Crude oil futures on the New York Mercantile Exchange is about $130 per barrel now.

If I lived in the United States it would be easy for me to buy oil ETFs (AMEX:USO) that would go up in value as oil goes up in value. It'd be as if I'm buying barrels of oil on the stock exchange. But alas I live in Australia so access to American investments are complex and costly. Investing in American crude oil is not a perfect hedge against rising petrol prices in Australia because crude oil and refined petrol are different products. Exchange rates between the Australian dollar and US dollar would also add another layer of complexity.

How then can I hedge against the rising costs of petrol? One of my friends jokingly told me to buy a bike. With the distances I have to travel this is just not practical. Plus I'm scared of loud trucks. Hopefully with higher petrol prices these loud trucks will go out of business.

Another idea is to invest in the resources, energy, or materials sector. One of the best performing and one of the most popular managed funds in Australia today is the Colonial First State Global Resources Fund. In the past year it has given investors a return of 27 per cent. In the past five years the average annual return is 30 per cent. Looking at this fund's top ten holdings, I notice that there are many familiar Australian faces like Rio Tinto, BHP Billiton, Xstrata, and Lihir Gold. There are also some Canadian companies in there like the Potash Corporation and Nexen. Instead of investing in the high-cost actively managed CFS Global Resources Fund, why not invest in an index fund that tracks the top Australian companies? This may work since Australia's top companies are heavily biased towards the resources and financial sectors. The financial sector is the largest sector in the MSCI Australia Index, making up approximately 40 per cent of the index. However, together the energy and materials sector make up 35 per cent of the index, which is quite a lot. Simply by investing in, say, the Vanguard Index Australian Shares Fund or the SPDR ASX200 ETF, you can probably get good exposure to Australian companies that deal with commodities.

Why just look at Australia? The MSCI Emerging Markets Index is very heavy with commodity companies, many of which are state-owned. The energy sector makes up 17.04 per cent of the MSCI EM Index while the materials sector makes up 12.99 per cent of the index. The energy sector and materials sector make up 11.39 per cent and 8 per cent of the MSCI World Index respectively, which is relatively low. This suggests that if you want exposure to resources companies, go to the emerging countries and Australia.

It is not that simple. Just because you invest in companies that deal with commodities, it doesn't mean you've hedged yourself against rising commodity prices. The cost of mining and transport might be higher, which may affect profitability. Even though commodity prices go up you may simply be investing in a bad company with bad managers and bad workers. Furthermore, many of these resource companies may specialize in gold, silver, and materials like iron ore. These may have little if not anything to do with oil or petroleum.


Cindy (Web Services) said...

Hi Norak,

Please note that the link to the Vanguard Australian Shares Index fund is now broken (due to a website update). That page can now be found here:$500000/australian-shares/australian-shares.cfm


Norak said...
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