Do you have interest in Vanguard Energy Funds? We have some information for you.

The first question we must ask ourselves about an energy sector fund is: Do we need it in our portfolio?

Yes, we all know that energy demand worldwide continues to grow. We can see that it can be very difficult to find more energy resources, and places where it is plentiful are some of the most volatile places on earth. We can even see that Vanguard would be a great place to look for these sector funds due to their low costs and superior index tracking capabilities but

Do we need Vanguard Energy Funds in our portfolio?

One group would argue that you probably already have fairly significant energy exposure in your portfolio. For example, the Vanguard S&P 500 ETF (VOO) has a 10.3% exposure to Oil and Gas, while the Vanguard Total Stock Market ETF (VTI) has a 9.3% exposure.

Another group would argue that energy is too important. They would want to control the amount of energy in their portfolio by using a Vanguard Energy Sector Fund, even if it meant doubling up on some, or most, of the energy stocks.

What would Harry Markowitz say?

In 1952, Mr. Markowitz brought us a concept, in modern portfolio theory, called the Efficient Frontier. Efficient Frontier portfolio software will take all of the asset classes that you are interested in, and create a curve similar to what you see in this chart. Under this curve, which is called the efficient frontier, are all of the possible portfolios for the given risk level. No portfolios exist above this curve. The actual curve represents the best investment returns possible for any given risk level. See How to Make an Investment Portfolio: 6 Steps to Better Investing  for a full understanding of how to make a portfolio.

What would happen if we made up a simple yet comprehensive three fund portfolio and tried to add energy to the portfolio?

Would the efficient frontier say we need to add energy, like Vanguard Energy Funds?

There are three parts to the efficient frontier: risk as measured by standard deviation, how the assets relate or correlate with each other, and the expected rate of return.

Here is our proposed three fund portfolio and the energy add on: (We used the Admiral Share index funds for the longer track records because these index funds are most similar to the ETFs.)

• Vanguard Total Stock Market Index Fund (VTSAX)
• Vanguard Total Bond Market Index (VBTLX)
• Vanguard Total International Stock Index (VTIAX)
• Vanguard Energy Index (VENAX)

We ran these four funds through Zephyr StyleADVISOR, our efficient frontier software. We found five different points on the efficient frontier, representing five different risk levels. We used beta to measure the risk of each portfolio. Beta is a measurement of volatility versus the S&P 500 Index. A beta of 1.00 is for a portfolio with the same volatility as the S&P 500 Index during the time frame being studied. We created portfolios at 0.20, 0.40, 0.60. 0.80 and 1.00 beta.

Here are the results if we use the historical return (past results from Oct. 2004 to Aug. 2014) as the expected return:

Source: Zephyr StyleADVISORTM

You can see that using the efficient frontier in this manner shows a great need for tremendous amounts of energy in the portfolio. Read How to Create Your Ideal Diversified Investment Portfolio   to fully understand the concepts behind portfolio design.

This is the problem with using past returns in the efficient frontier calculation. It shows you what would have worked the best. Unless you have a time machine you want to know what will work the best. Unfortunately, we are fresh out of crystal balls.

What should we do to get a more realistic portfolio?

We handle the concept of future expected returns by using the Capital Asset Pricing Model (CAPM), which is a well-established mathematical model that estimates returns based on market risks. In general, the more risk an asset has the more the expected return. Each asset placed into the efficient frontier model is given a return based on the CAPM instead of using historical returns or simply guessing about what returns might be in the future. There are lots of problems with CAPM as well, but it is still better than using historical returns.

Using CAPM to calculate the expected returns we get a much different portfolio set:

Source: Zephyr StyleADVISORTM

Using the more realistic and balanced CAPM returns produced portfolios that have essentially no extra energy sector needed.

In summary, if the past repeats and energy outperforms, then we will all wish that we had an over abundance of energy in our portfolios, like Vanguard Energy Funds. Unfortunately, the past is often a poor predictor of future performance. We prefer to create globally diversified core portfolios using Index Funds and ETFs without the use of sector funds like energy. We believe that you cannot determine where the market is going in the future, and making a bet on a sector like energy is not necessary to achieve good returns.

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