Why Investing in Fossil Fuels Is So Tricky

As concerns about climate change push the world economy toward a lower-carbon future, investing in oil may seem a risky bet. For the long term, that may be true.

Yet for the moment, at least, oil and gas prices appear likely to continue to rise as the economy recovers from the pandemic-driven shutdown of millions of businesses, big and small.

These countervailing trends — increasing demand now and falling demand at some point, perhaps in the not-too-distant future — create a dilemma for investors.

The good news is that an array of traditional mutual funds and exchange-traded funds are available to help them navigate these uncertain waters. Some funds focus on slices of the industry, such as extracting crude oil and gas from the ground or delivering refined products to consumers. Others focus on so-called integrated companies that do it all. Some spice their holdings with some exposure to wind, solar or other alternative energy sources.

International Energy Agency forecast that oil consumption was not likely to return to prepandemic levels in developed economies.

“World oil markets are rebalancing after the Covid-19 crisis spurred an unprecedented collapse in demand in 2020, but they may never return to ‘normal,’” the I.E.A. said in its “Oil 2021” report. “Rapid changes in behavior from the pandemic and a stronger drive by governments toward a low-carbon future have caused a dramatic downward shift in expectations for oil demand over the next six years.”

alternative energy funds. Many enable investors to zero in on discrete segments of the industry.

The biggest holdings of the Invesco WilderHill Clean Energy E.T.F. are producers of raw materials for solar cells and rechargeable batteries or builders and operators of large-scale solar projects. The $2.9 billion fund yields 0.49 percent and has an expense ratio of 0.7 percent.

The First Trust NASDAQ Clean Edge Green Energy Index Fund focuses on applied green technology. Its biggest holdings are Tesla, the American maker of electric automobiles; NIO, a Chinese rival in that field; and Plug Power, which makes hydrogen fuel cells for vehicles. Also a $2.9 billion fund, it yields 0.24 percent and has an expense ratio of 0.6 percent.

The First Trust Global Wind Energy E.T.F., as its name suggests, targets wind turbine manufacturers and servicers, led by the Spanish-German joint venture Siemens Gamesa Renewable Energy and Vestas Wind Systems of Denmark, as well as operators such as Northland Power of Canada. This $423 million fund yields 0.92 percent and has an expense ratio of 0.61 percent.

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For Bonds, Add Safety by Venturing Abroad

Making your bond-fund portfolio less risky requires doing something that can feel like living dangerously: investing abroad.

If you’re like most people, you may have put too much of your money in bond funds invested in your home market and so failed to spread your bets around.

“People are used to thinking about diversification in their stock portfolio, and they understand how that works to control the risk,” said Rob Waldner, chief strategist for fixed income at Invesco. “You need to do that with your fixed income, too.”

Bond diversification matters all the more when traditional income producers like U.S. Treasuries are paying measly rates, he said.

1.7 percent in early April, compared with less than 1 percent in January. But rates are likely to remain relatively low by long-term standards.

Bonds come in a variety as rich — and sometimes baffling — as the screw-and-fastener aisle at Home Depot.

A well-diversified portfolio might include mutual funds or exchange-traded funds that buy bonds issued by the United States and foreign governments, and large U.S. and foreign companies, as well as ones backed by mortgages, auto loans or credit-card receivables in the United States. (Pools of these financial assets are securitized, and rights to payments from the pools become mortgage-backed and asset-backed bonds.)

“Home bias” is the financial term for people’s tendency to over-invest in their home market and shy from other places. Investment experts say it’s pervasive.

“It’s something we observe in every country,” said Roger Aliaga-Diaz, global head of portfolio construction at Vanguard.

Vanguard’s research has found that international bonds reduce portfolios’ ups and downs without hurting the total return. Internationally diversifying can provide access to securities from more than 40 countries.

“This broad exposure is important, as the factors that drive international bond prices are relatively uncorrelated to those that drive prices in the U.S.,” the report said. Lately, for example, South Korea’s 10-year government bond is yielding 2 percent, while Mexico’s is yielding nearly 7 percent.

The international bond slice of Vanguard’s target-date funds is invested in the Vanguard Total International Bond Index Fund, which owns mainly developed-world bonds. Like many international bond funds, it uses hedging to protect its shareholders against the return volatility that currency fluctuations can cause.

Jean Boivin, head of the BlackRock Investment Institute, said his outfit’s research suggests that investors may want to be bold in their foreign bond forays and look beyond developed markets.

“You need to think about emerging-market bonds and, in particular, Asia ex-Japan,” he said.

In the past, investors could view the U.S. bond market as a proxy for the world, partly because U.S. companies often had sprawling international operations, Mr. Boivin said. But there is enormous global diversity today. Foreign markets, especially China, have risen so much that this approach doesn’t work as well.

Total Return Fund might provide a starting point for considering reasonable ranges. It recently allocated about 8.6 percent of its assets to emerging markets.

The Fidelity Total Bond Fund, another broad offering, lately had a 16 percent stake in higher-yielding, riskier kinds of domestic and foreign debt.

“Historically, we’ve owned from 8 to 18 percent in the higher-yielding sectors,” said Celso Munoz, one of the fund’s managers. “It’s appropriate for most people to have exposure to the broader fixed-income world, which would include high yield, emerging markets and bank loans.”

People may tend to shun international bonds partly because stocks overshadow bonds in the popular media, said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research.

“Every day somebody is talking about the S&P 500 or the Dow,” she said. “People don’t talk like that about Bloomberg Barclays U.S. Aggregate Bond Index,” a leading bond index, and relatively few people plunge even deeper into the fixed-income universe.

To decide how you might better diversify your bond funds, it helps to reflect on why you own them, said Tad Rivelle, chief investment officer for fixed income at TCW.

“The existential question is do you think of fixed income as a safe asset that enables you to take risk elsewhere,” he said, “or do you expect your bonds to pull their own weight, and so you’re OK with them going down in a market panic?”

MetWest Total Return Bond Fund might work for the first group, and its MetWest Flexible Income Fund for the second.

A puzzle for all bond-fund investors is how the end of the Covid-19 pandemic might affect interest rates.

Rates usually rise when the economy grows, as it’s expected to do as the world emerges from the pandemic. As that happens, inflation may rise, which could stifle a long bull market in bonds. Bond prices rise as interest rates fall.

Yet renewed inflation has been erroneously predicted before, and Jerome Powell, the chair of the Federal Reserve, has made clear that the bank isn’t rushing to raise the short-term rates it controls.

For investors who are counting on their bond funds for income, continued low rates could create a temptation to court risk.

A more patient approach is prudent, said Mary Ellen Stanek, chief investment officer for Baird Advisors, which oversees the Baird Funds.

“You don’t own bonds for excitement and drama,” she said. “You own them for predictability and lower volatility.”

Ms. Jones of Schwab warned, too, against seeking excessive risk. She suggested investors instead rethink how they take cash from their portfolios.

“In a year when your stocks are up 20 percent and your bonds are up 2, you may want to pull out some of those capital gains and put them in your cash bucket,” she said. “Say you’re looking to generate 6 percent overall, and you’ve made 20 percent in stocks. If you have excess above your plan, you can look at that as potential income.”

No matter what path investors choose, they should always pay close attention to the costs of funds and E.T.F.s, said Jennifer Ellison, a financial adviser at Bingham, Osborn & Scarborough in San Francisco.

“Costs are really important, especially with yields where they are,” since those costs will eat up much of that scant yield, she said. “If you’re a retail investor and you’re buying a loaded bond fund, you’re giving all your yield away up front.”

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As Talk Turns to Inflation, Some Investors Look to Gold

Inflation is back in the news and so, of course, is interest in gold.

After years of dormancy, inflation is expected to rise a bit this summer. It is even possible that as Americans emerge from Covid-19 induced seclusion, their pent-up demand will overheat the economy and weaken the dollar.

Those concerns have put the spotlight on gold, which has long been viewed as a hedge against inflation, a declining dollar and an unstable stock market. Buy gold now and make a quick profit, or so the thinking goes.

But this analysis has problems, starting with the outlook for inflation, which isn’t necessarily that bad. The inflation rate ended 2020 at an anemic 1.4 percent, and Jerome H. Powell, the Federal Reserve chair, has said that despite the potential for a modest surge above 2 percent this summer, the Fed doesn’t expect inflation to move much higher between now and 2023.

Perhaps that’s why gold hasn’t been soaring lately, either. After peaking at more than $2,000 an ounce last summer, gold prices hovered below $1,750 in early April, a decline of nearly 13 percent.

Warren E. Buffett likes to point out. Finally, investors who buy physical gold face the additional risk and cost and of securing their bullion or coins.

A more cautious approach is to avoid chasing returns. Instead, keep a small percentage of a portfolio in gold and other precious metals in the hope that this will be a long-term stabilizer.

“In a world where equity prices continue to elevate untethered to any fundamentals, precious metals as a small amount of diversification makes sense,” said David Trainer, chief executive of New Constructs, an investment research firm based in Nashville.

George Milling-Stanley, chief gold strategist at State Street Global Advisors, said gold offers two benefits over the long term: protection against risk and volatility, and as asset appreciation.

“Gold is a defensive asset that really comes into its own over the long term, when you can enjoy the return stream,” Mr. Milling-Stanley said.

restrained, rarely rising above 3 percent annually and remaining around 2 percent or less most of the time. Gold prices, however, rose from $274 an ounce at the beginning of 2001 to about $1,750 at the end of March.

“We don’t need inflation,” Mr. Milling-Stanley said. Gold performed well anyway.

Some experts recommend investors stick to E.T.F.s that focus strictly on gold, which tends to lead the other precious metals, silver and platinum. Advisers warn that gold, precious metals and other commodities should make up just a sliver of an individual’s portfolio, usually no more than a total of 5 percent.

Whatever its drawbacks as an investment, gold has had an enduring appeal.

“There is a psychological component in owning gold that goes back for centuries,” Ms. Simonetti said. “It’s an asset that gives peace of mind to investors. It just makes investors feel safe and secure.”

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As Investors Switch to E.T.F.s, So Do Managers

One of the most persistent investment trends is the migration of money out of stock mutual funds and into exchange-traded funds, which are easier to trade, have lower operating expenses and often have favorable tax treatment.

Over the last 10 years, a net $900 billion has flowed out of stock mutual funds and $1.8 trillion has flowed into stock E.T.F.s, according to Morningstar.

Eager to give the public what it wants, and to keep shareholders from walking out the door with their assets, some fund providers have begun to convert stock mutual funds into E.T.F.s. Others run E.T.F. versions of their popular mutual funds, and one company, Vanguard, allows tax-free direct swaps of mutual fund positions into equivalent E.T.F.s.

E.T.F.s are simpler and cheaper for managers to run than mutual funds. Investors benefit when the savings and convenience are passed on to them, and from other inherent advantages that drove the rise in E.T.F.s in the first place.

“There are real benefits to having more E.T.F.s, especially in larger, more liquid funds,” said Christopher Cordaro, chief investment officer of RegentAtlantic, a Morristown, N.J., financial-planning firm. “If I’ve got two versions of something and the E.T.F. has a lower-cost portfolio, it’s an easy decision to use the E.T.F. over the mutual fund.”

The decision to test the conversion concept was not all that easy for Guinness Atkinson Asset Management, which was the first fund provider to do it, said Todd Rosenbluth, director of E.T.F. and mutual fund research at CFRA Research. Jim Atkinson, Guinness Atkinson’s chief executive, said the plan was studied for two years. It was carried out in late March when Guinness Atkinson Dividend Builder and Guinness Atkinson Asia Pacific Dividend Builder became E.T.F.s listed on the New York Stock Exchange.

“This is a trial balloon for other funds,” he said. “Operationally, we want it to go OK.”

If it does, the firm’s alternative energy fund is up next. Mr. Atkinson conceded that while “there may be funds that are better as open-end mutual funds, our intention is to convert all of our funds.”

Dimensional Fund Advisors is sending aloft a trial balloon of its own. It plans to convert six stock mutual funds into E.T.F.s, with the first four conversions set for June. The new structure will allow it to reduce its annual management fee to 0.23 percent from about 0.32 percent on average.

A third fund provider, Foothill Capital Management, filed last month for approval to convert its Cannabis Growth Fund, with about $7 million of assets, into an E.T.F.

E.T.F.s are cheaper to run in part because the management company can stay out of the way and let buyers and sellers deal with one another. Operating a mutual fund means handling new investments and redemptions every day and having cash on hand in case redemptions significantly exceed sales.

Another advantage often accruing to E.T.F. shareholders is favorable tax treatment. Mutual funds generally have to distribute capital gains each year, whereas an E.T.F., like a stock, incurs tax liability only when the owner sells at a profit.

Converting a mutual fund to an E.T.F. is legally a merger of the old fund with the new, Mr. Atkinson said, and is thus not a taxable event.

Vanguard is using a different technique to let investors in 47 of its index mutual funds, 36 that own stocks and the others bonds, move their assets into E.T.F.s free of tax consequences. Each E.T.F. was created as a share class of the equivalent mutual fund, which the law regards as a nontaxable transfer.

Vanguard has no plans to convert any mutual funds, said Rich Powers, its head of E.T.F. and index product management, nor does the company expect to create E.T.F. share classes for any actively managed mutual funds.

Other fund providers run E.T.F. versions of their large index-based mutual funds, but Vanguard has a patent on the technique of tax-free transfers between share classes. Mr. Powers said there were discussions with other fund providers about licensing it, but none have taken the plunge, perhaps because the patent expires in two years and other companies may be waiting until then to offer such transfers.

Whichever companies follow in the footsteps of Guinness Atkinson and Dimensional in making conversions are not expected to be industry giants. Indeed, several of the largest fund providers — BlackRock, Vanguard, T. Rowe Price and Fidelity — said they had no intention to convert their mutual funds.

There are two reasons that conversions are more appealing to smaller firms. Mr. Cordaro noted that mutual funds can be bought and sold free of charge on platforms run by brokerages. The brokerages need large, popular fund providers — the BlackRocks of the world — to attract investors, but smaller managers need the platforms more than the platforms need them, so they often have to pay to be on them. E.T.F. managers face no such demand.

The other impediment for large managers is a feature of E.T.F.s that they might view as a bug, at least when it comes to actively managed portfolios: the requirement that most E.T.F.s disclose their holdings daily.

Disclosure is seldom a problem for smaller funds, which usually complete portfolio trades the same day. Mr. Atkinson said that is the case with the two funds that have been converted. But large funds may need several days to execute significant portfolio changes to avoid moving the market. If an E.T.F. discloses that it has begun buying or selling a particular stock, traders may jump in and do the same to try to take advantage of anticipated price movements.

Another issue that Mr. Powers cited to explain why Vanguard does not offer actively managed E.T.F.s, and would not be inclined to convert actively managed mutual funds, is that there is no way to restrict investment in an E.T.F. If a mutual fund in a frothy market segment attracts too much money, making managing the portfolio unwieldy, the manager can limit new investment, but that isn’t allowed with an E.T.F.

E.T.F. conversions may be limited to smaller funds, but Mr. Cordaro would worry about trying one with anything too small.

“There’s an ongoing downside to smaller, more thinly traded E.T.F.s when you have turmoil in the markets,” he said. “During big down days, when there’s a lot of dislocation or volatility, there can be a big discount” to a fund’s net asset value, “or a big impact on the bid-ask spread,” the difference between the price at which buyers buy and the slightly lower price at which sellers sell.

Whatever size portfolio might be the object of a conversion, Mr. Rosenbluth anticipates more of them after the first have had any kinks resolved and have been shown to be successful.

“We’re likely to see more of these once these pioneering strategies make the effort and we see that investors don’t revolt, and stay within the fund,” he said.

A potential limit on conversions is that “some investors are still comfortable with mutual funds,” Mr. Rosenbluth added. “What I hear from asset managers is they want to give investors choice.”

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