As news of social unrest in Iraq has saturated the American media, investors have become a little jittery. The S&P 500 broke its uptrend and ended the weak 0.6 percent lower. Meanwhile, the price of oil rallied 4 percent on supply concerns. Safe haven assets also rallied, with gold rising nearly 2 percent and long-term Treasury Bonds rallying 0.5 percent.
Given the potential for a conflict in the Middle East, I think investors should prepare their portfolios accordingly. When doing so, investors should not forget that there is also geopolitical tension between the U. S. and Russia, and this only bolsters the case for owning the following funds.
When buying these funds, investors should keep in mind that they have all performed well this week, and therefore it is prudent to wait for a pullback.
1. The iShares Oil and Gas Exploration and Production ETF (NYSEARCA:XOP)
Iraq is not a major global oil producer but this week we saw the price of oil soar, and with it we saw a rise in the shares of oil exploration and production companies. The XOP has been a phenomenal performer year-to-date, having risen over 17 percent as the price of oil has spiked over 10 percent. While investors may first look towards the more popular SPDR Energy ETF (NYSEARCA:XLE), the XOP is more geared towards companies that are leveraged to the price of oil. It also doesn’t include any coal companies that have been underperforming for the year. This fund closed on Friday at an all time high to the penny, and therefore, I think investors need to be cautious and wait for a pullback of 3-4 percent.
2. The United States Oil Fund LP (NYSEARCA:USO)
While you may get more leverage in buying the oil producing companies if you want straight up oil exposure, then simply buy a fund that tracks the price of oil. Keep in mind that oil companies have to endure risks such as rising input costs, regulations and taxes, and if the price of oil soars due to an unlikely yet possible war in the Middle East, then we could see oil companies underperform if there is a windfall profits tax or if people stop using so much oil.
Therefore, the USO is an alternative fund to consider to the XOP for your oil exposure. It will rise and fall with the price of West Texas Crude Oil, which is up about 10 percent for the year. One concern that I have with this fund is that at the end of every month the fund sells its existing futures contracts in order to buy the next month’s contracts. This means that it has to pay brokerage fees. It also contracts from different months trade at different levels. Now this could serve to benefit USO holders, but it may not, and this adds an additional risk dimension.
3. The Advisor Shares Ranger Equity Bear ETF (NYSEARCA:HDGE)
Rising oil prices hurt the rest of the economy, and this can put pressure on stocks. Stocks are already trading at lofty valuations that are historically very high, and so the risk that an international conflict drags shares down substantially is heightened.
While there are a lot of short-selling funds out there, I like this one. This is a managed fund that does more than simply track the inverse of an index, which is the strategy used by the more popular funds. Instead, the fund managers try to find companies that are especially vulnerable to the downside. Specifically, they look for this vulnerability in “aggressive” accounting. Aggressive accounting isn’t necessarily illegal, but it tries to make the company’s financials look better than they actually are. For example, during the financial crisis many banks increased the amount of money the set aside to cover losses in the event of loan defaults. As that perceived risk abated, they took this money out of reserves, but when doing so they called this money “earnings.” Intuitively, we know that this is nonsense, but it makes their earnings look better to the untrained eye.
HDGE’s managers are trained to spot these and other similar aggressive accounting techniques in order to find mis-valued assets to short. So far this year the fund has slightly outperformed the Proshares Short S&P 500 ETF (SH) by about 2 percent.
4. The Sprott Physical Gold Trust (NYSEARCA:PHYS)
This is a great way to get exposure to gold, and the price of gold will rise in the event of an international conflict as investors fear stocks and potentially bonds. The gold price was up nearly 2 percent last week, and it seems to have been making a firm base above the $1,200/ounce level. An international conflict such as war in Iraq could be the catalyst that drives gold into the next phase of its now 13 year bull market.
I like this fund more than the more popular SPDR Gold Trust (NYSEARCA:GLD) because it has a better tax situation. The latter treats gold as a collectible, and any profits are taxed at the collectible tax rate of 28 percent. PHYS is essentially a stock, and so if you hold it for more than a year then your gains are taxed at the capital gains rate of 15 percent or 20 percent.
5. The Powershares Aerospace and Defense ETF (NYSEARCA:PPA)
This fund actually fell last week by nearly 2 percent, but this fund holds the sort of stocks that will perform well in the event of a war. If we do have the need for military intervention in Iraq, it follows that defense spending will rise, and the companies in this fund will perform very well.
One thing to note is that a couple of the companies in this fund, notably Boeing (NYSE:BA), make commercial airplanes. In a rising oil price environment airlines will suffer margin compression and be forced to raise prices. This means fewer people will fly and Boeing will produce fewer commercial airplanes. So there is some risk with this fund. However, generally these companies focus on defense contracting, and they are relatively inexpensive and very shareholder friendly.
Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.