Saturday, June 07, 2008

The Risk In Hedging Energy Exposure

One concern being discussed by investment strategist and business news commentators is the thought that the sharp rise in many energy stocks is being driven by investor speculation. If individual investors want to protect against a potential sharp drop in their energy holdings, they can hedge the exposure via investment products like the Proshares UltraShort Oil & Gas (DUG) exchange traded fund. The UltraShort Oil & Gas Proshare seeks:
daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Oil & Gas IndexSM.
Yesterday, crude oil futures increased $10.75. This was the the largest, single-day price gain ever. Oil prices closed at a new record high of $138.54 per barrel, surpassing the May 21st record of $133.17. With this sharp spike in crude oil futures, one would think the UltraShort Oil & Gas Proshare would have declined. In fact, DUG actually rose 2.47%!

The lesson in this example is one should be aware of the underlying components in these types of indexes. The four largest positions in the Dow Jones Oil & Gas Index (DJUSEN) are:

Dow Jones Oil & Energy Index top four holdingsAs detailed in the above table, the four largest holdings in the Dow Jones Oil & Gas Index all declined on Friday. Additionally, these four holdings account for 49.34% of the overall index. So, if oil prices decline will the the UltraShort Oil & Gas Proshare rise?

In conclusion, if an investor is looking to hedge any position or sector within their overall account, understanding the components of the hedging product is vitally important.

(Disclosure: I hold a position in the Dow Jones Oil & Gas Proshare)

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