For many investors, seeing the impressive returns generated by the oil and gas industry is sometimes a frustrating experience. Yes, the sector can be extremely lucrative, but it is also fraught with difficulties that make the barrier to entry high for newcomers. As noted previously, valuing companies in the energy sector is quite different to valuing companies elsewhere, requiring investors to learn a completely new set of metrics and skills. Luckily, there is a way to gain exposure to the energy market without having to select individual stocks -- via energy ETFs (exchange-traded funds).
What is an energy ETF?
As you may know, an ETF is simply a security, the value of which tracks some underlying asset, be it a basket of stocks, a commodity, a real estate portfolio or so forth, ETFs can be valuable to investors who wish to gain broad exposure to a given market. Accordingly, energy ETFs give investors exposure to the energy market. There are many different types of energy ETF: funds that own a basket of stocks and ones that own futures, funds that allow investors to be long the market and ones that allow investors to be short the market. This can all be very confusing to a new investor, so for today we will focus on probably the most popular type of energy ETF: one that gives exposure to good old-fashioned stocks.
What are the different types of energy equity ETFs?
These can be further divided based on their risk/reward profile. More conservative investors will probably opt for a fund with a solid base of large-cap stocks, but there are many different options if you are willing to be a little more daring:
Large-cap ETFs. These are the bread and butter of the industry, with the SPDR Energy Select Sector (XLE, Financial) being by far the largest one. With almost $14 billion in assets under management, and with industry giants Exxon Mobil (XOM, Financial) and Chevron (CVX, Financial) together accounting for almost 40% of the total holdings, this can definitely be considered the Big Oil ETF. Other options in this category include the Vanguard Energy ETF (VDE, Financial), which is notable for having the lowest expense ratio in this category (the percentage of your investment that will be taken out as fees) at 0.10%.
Diversity ETFs. For investors with a higher tolerance for risk, diversity ETFs provide an opportunity to invest in some up-and-comers with the greater upside potential that this implies. These will typically have a core of larger companies, and a wider range of diverse mid- and small-caps. The John Hancock Multi-Factor Energy ETF (JHME, Financial) is a good example of this -- 63% of its holdings are large caps, with the rest being smaller energy companies.
Emerging market ETFs. The market for energy is global in a way that few other markets are. The price of oil is subject to a huge variety of geopolitical factors, and there are of course many countries outside of the U.S. where oil and gas production is a major industry. For this reason, there exists a class of ETF that gives investors access to the energy market in places like Russia, Brazil and China. There are even ETFs that bundle up stocks from different emerging markets in an attempt to offer more diversification. Be warned though, emerging markets like the ones listed above are subject to significantly higher levels of volatility, both due to their own domestic issues, and also because in times of global uncertainty capital tends to flow back to safer havens.
Summary
Energy ETFs offer an easy way to take a position in the oil and gas market without having to pick and choose individual stocks. Depending on your appetite for risk, there are many different routes you can take in this sector, from buying and holding the biggest players on the market to betting on smaller companies with more upside.
Disclaimer: The author owns no stocks mentioned.
