Pros and Cons to Energy ETF Investing

For those who are not experts in crude oil prices and other facets of the oil and gas industry, adding exchange-traded funds is one way to gain exposure to this sector.

Energy ETFs often offer a broader mix of holdings, particularly ones that mimic an index. It also takes out some of the guesswork in understanding how oil prices fluctuate in the market, says Mike Loewengart, chief investment officer at E-Trade Financial, a New York-based brokerage company.

“ETFs let investors more easily trade into and out of positions since they are publicly sold on an exchange,” he says. “Investors should understand that the price of crude oil can play a major factor in the performance of individual oil stocks.”

He adds energy ETFs can lessen “some of the lockstep movement between stocks and oil prices.”

Here are few pros and cons of investing in energy ETFs:

— Energy stocks may generate higher returns.

— ETFs are for a long-term approach.

— Energy ETFs can be diversified.

[See: 9 ETFs to Invest in Solid Alternative Assets.]

Energy Stocks May Generate Higher Returns

One of the advantages of owning individual stocks is knowing the quality and financial outcome of a company. Investors also have more control in avoiding the lower quality names in an ETF, says Patrick Kaser, a portfolio manager at Brandywine Global Investment Management in Philadelphia.

“With a little bit of research, you can get more exposure to what it is that you’re looking for,” he says.

An investor who is seeking oil companies that are only producing free cash flow right now will not find an ETF that focuses on it. Instead, an investor could buy a small group of companies such as Chevron Corp. (ticker: CVX), ConocoPhilips ( COP) and Canadian Natural Resources ( CNQ) and put together a portfolio of large oil companies along with exploration and production and oil-sands plays with long-lived assets, Kaser says.

One issue with owning ETFs is the variance compared to the underlying commodity because of how futures are purchased, he says. As of May 2019, the year-to-date performance difference for crude ETFs varies. The United States Oil Fund ( USO), the largest, is up by about 33 percentage points, and the second largest, Invesco DB Oil Fund ( DBO), is up by nearly 31 percentage points compared to last year at this time.

The largest energy and production ETF, SPDR S&P Oil & Gas Exploration & Production ETF ( XOP), includes Anadarko Petroleum Corp. ( APC) as its largest holding at the moment.

“That’s a company with essentially zero upside given its impending acquisition by Occidental Petroleum ( OXY),” he says.

But choosing stocks means devoting time and energy, Loewengart says. Investors are likely to gravitate toward familiar names like Exxon Mobil Corp. ( XOM) and Chevron in the energy sector.

“These common blue-chip stocks may be sound investments, but focusing on individual stocks can be risky if you don’t take into account your portfolio as a whole,” he says. “Not all companies are created equally even though they’re within the same industry.”

Individual equities require a thorough analysis of the company’s fundamentals such as management makeup and earnings performance, experts say.

“If you have the time to research the technical and fundamental indicators of a specific stock, it can be exhilarating to participate in the potential growth of a company,” he says. “On the flip side, if you simply want to get involved in the market, ETFs could be more appropriate for you.”

[20 of the Best ETFs to Buy for 2019.]

ETFs Are for a Long-Term Approach

One issue with adding single stocks of crude oil or renewable energy companies is that they are impacted by external factors such as global sanctions and regulations, which can affect supply and demand and ultimately price, he says.

“Given the potential for volatility in the oil sector, it’s important to stay diversified to help mitigate price swings,” Loewengart says.

Investors can drown out some of the noise by adding mutual funds or ETFs, “especially if there are a fair amount of underlying holdings,” he says. “While active fund managers select individual stocks to try to beat the market, anyone who simply wants to participate in the market should be thinking about index ETFs.”

The number of energy ETFs has expanded to include either the entire market or a specific segment, giving investors many choices such as Energy Select Sector SPDR ( XLE), which holds large-cap U.S. energy stocks, says Rob Thummel, a portfolio manager at Tortoise Capital. This ETF provides exposure to the largest stocks in the energy sector, but more than 40% of it is comprised of Exxon Mobil and Chevron, so investors receive a lot more international exposure to oil and gas production. It also does not offer as much exposure to the U.S. energy sector as well as limited exposure to energy infrastructure and refining sectors, he says.

Replicating the S&P oil and gas exploration and production industry index, XOP, is more of an equal weighted index, which focuses more on U.S. oil and gas production, he says. The equal weighting does not appropriately distinguish quality because not all oil and gas producers are the same.

“Investors in XOP miss out of the Permian story by being underweight pure-play Permian producers,” Thummel says.

Some ETFs only invest in a segment of the energy sector such as the midstream sector, which consists of pipelines, oil field services or natural gas producers. Experts say looking at the underlying holdings is critical.

The Alerian MLP ETF ( AMLP) provides exposure to the energy midstream sector, but it is not tax-efficient for investors and the maximum weights are too high, Thummel says.

[See: 7 of the Best Bond ETFs to Buy Now]

Energy ETFs Are Diversified

ETFs are a simpler way to diversify a portfolio. The Vanguard Energy ETF ( VDE) includes large, midsize and small U.S. companies and allows investors to add energy businesses to their portfolios “without going all in on any one security,” Loewengart says.

During times of volatility in the market, ETFs “carry the advantage of diversification, says Ryan Giannotto, director of research at GraniteShares in New York.

The influence of algorithmic trading means that individual stocks can take “seemingly irrational twists and turns as the machines make their bets,” he says.

A diversified fund can reduce an investor’s exposure to the negative impact of any specific stock.

“Just imagine the cost in the trading fees of acquiring and rebalancing 30 or more stocks, compared to an ETF,” Giannotto says.

ETFs can also provide exposure to unique markets.

“They allow you to invest in stocks around the globe, which may be hard to access individually,” he says. “There are almost 50 different individual countries which can be invested in through [energy] ETFs.”

While ETFs do not get as granular as a single stock, one can invest at the industry level. For instance, there are ETFs that invest in oil & gas exploration and there are other funds that focus on production companies such as XOP as well as those investing in energy equipment and services companies like VanEck Vectors Oil Services ( OIH), says Kostya Etus, a portfolio manager at CLS Investments, an ETF strategist based in Omaha, Nebraska.

He adds stocks may offer more return potential if you make the right selection, but ETFs are more diversified and tend to have less risk, lowering the chances of “significant losses as compared to individual stocks, which have the possibility of going bankrupt and the stock price going to zero.”

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