While many investors hold the core of their portfolios in low-cost index funds, some opt to “tilt” toward certain sectors in order to achieve different objectives. For example, in 2020 many tilted toward technology sector stocks thanks to a low-interest-rate environment, which sent their valuations rocketing as investors sought high-growth opportunities.
In 2021 and 2022, the narrative changed. As inflation crept upward, interest rates did as well, sending the favored sectors and assets of 2020 crashing downward. Tech stocks, growth stocks and cryptocurrency all severely underperformed the market as valuations fell to more sensible levels. As investors adopted a risk-off attitude, their money left more speculative assets.
On the other hand, more traditional sectors like energy saw a dramatic resurgence, with the S&P 500 Energy Index recording a total return of 54.6% and 65.7% in 2021 and 2022, respectively. Aided by soaring commodity prices, U.S. energy companies reported record profits and initiated large share buybacks as investors flocked to them in search of an inflation hedge.
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The future of the energy sector looks bright, too, thanks to the increasing importance of renewable energy sources. “The adoption of renewable energy is accelerating, particularly for the wind and solar power industries, as governments and corporations ramp up decarbonization efforts to help mitigate climate change and boost energy security,” says Madeline Ruid, research analyst at Global X ETFs.
“In addition, ongoing advancements in clean technologies, such as wind turbines, solar modules and energy storage systems, could expand the suitability range for renewable energy systems and potentially make it even more cost competitive,” she says. That being said, buying and holding individual energy stocks, whether traditional or renewable, isn’t the most diversified approach.
“Even if investors are right about sector macro trends, it’s still difficult to make perfect stock picks in energy given all of the moving parts,” says Travis Hoium, investing analyst and creator of the Riiv Project.
Thus, investors can opt for maximum diversification via exchange-traded funds, or ETFs, which hold a portfolio of energy stocks based on an underlying index or a proprietary methodology. “The basket approach of an ETF is a great way to get energy exposure without single-company risk,” Hoium says.
Here’s a look at the seven best energy ETFs to buy in 2023:
— Vanguard Energy ETF (ticker: VDE)
— United States Oil ETF (USO)
— Energy Select Sector SPDR Fund (XLE)
— SPDR S&P Oil & Gas Exploration & Production ETF (XOP)
— VanEck Oil Services ETF (OIH)
— Global X Renewable Energy Producers ETF (RNRG)
— First Trust Nasdaq Clean Edge Green Energy Index Fund (QCLN)
Vanguard Energy ETF (VDE)
“For energy sector ETFs, I primarily look for a combination of high diversification and minimal fees,” Hoium says. “For example, the Vanguard Energy ETF has over 50% of its assets in major oil and gas producers and the expense ratio sits at just 0.1%,” he says. This works out to $10 in annual fees for a $10,000 investment, which is very competitive.
VDE tracks the Spliced U.S. Investable Market Energy 25/50 Index, which holds 112 U.S. energy stocks spanning multiple oil and gas industries: drilling, equipment, services, exploration, production, refining, marketing, storage and transportation. Due to its market-cap-weighted construction, 22.8% and 15.1% of VDE are held in Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX), respectively.
United States Oil ETF (USO)
ETFs holding energy stocks have exposure to commodity prices but are ultimately still equities. For those looking for an energy play with lower correlation to equity markets, commodity ETFs like USO could be a solution. This ETF holds a portfolio of West Texas Intermediate (WTI) crude oil futures contracts and charges a heftier 0.81% expense ratio.
“If you’re looking at commodity ETFs like USO, you need to understand the mechanics of how it works,” Hoium says. “In a normal oil market, the fund is in contango, meaning that it is literally selling futures contracts low and buying higher every month to maintain exposure,” he says. Accordingly, USO has historically underperformed the spot price of oil, making it best suited as a short-term trading tool.
Energy Select Sector SPDR Fund (XLE)
Investors looking for a possible tax-loss-harvesting partner for VDE can consider XLE, which has similar top holdings but tracks the Energy Select Sector Index instead. This index only targets the energy stocks represented in the S&P 500 index, which gives it a much narrower and large-cap focus. Currently, XLE has just 23 holdings, and it charges a 0.1% expense ratio.
As with VDE, the market-cap-weighted methodology used by XLE means that large energy-sector stocks like Exxon Mobil and Chevron dominate the ETF, at 23.8% and 18.9%, respectively. However, the name-brand recognition of XLE’s underlying index provides it with good liquidity characteristics, such as an options chain and a minuscule 30-day bid-ask spread of 0.01%.
SPDR S&P Oil & Gas Exploration & Production ETF (XOP)
Investors looking for a more concentrated energy play can delve deeper into the sector by focusing on one of its many sub-industries. Possible targets include companies that focus on oil and gas exploration, production and refining. Notable U.S. stocks in this industry include Marathon Petroleum Corp. (MPC), Valero Energy Corp. (VLO) and Diamondback Energy Inc. (FANG).
To track these stocks plus 56 more, investors can buy XOP, which targets the S&P Oil & Gas Exploration & Production Select Industry Index. Unlike the previous ETFs, XOP uses a modified equal-weight methodology, which results in a far more uniform portfolio. This provides XOP with greater exposure to small- and mid-cap oil and gas stocks, while reducing concentration in large-cap energy stocks.
VanEck Oil Services ETF (OIH)
To complement XOP, investors can buy OIH, which tracks companies involved in the oil services, equipment and drilling industries. The broad categorization for companies that provide these services is “upstream,” with notable names in OIH including Schlumberger NV (SLB), Halliburton Co. (HAL) and Transocean Ltd. (RIG) out of a total of 25 holdings.
OIH has a 30-day SEC yield of 0.7%, but in a taxable brokerage account, a lower dividend is not necessarily a hindrance, as it can reduce the overall tax drag of an investment. A potential strategy is to put higher-yielding oil and gas exploration ETFs in a tax-advantaged account, and put oil services ETFs like OIH in a taxable account. OIH charges a 0.35% expense ratio.
Global X Renewable Energy Producers ETF (RNRG)
As noted, investors looking to invest in the “future” of the energy sector can target the renewable energy industry. “We believe the enactment of the Inflation Reduction Act in the U.S. and its expansion of tax credits creates strong tailwinds for a range of clean energy sources, including wind power, solar power and low-carbon hydrogen,” Ruid says.
A potential ETF to consider here is RNRG, which holds 47 downstream companies that produce energy from renewable sources including wind, solar, hydroelectric, geothermal and biofuels by tracking the Indxx Renewable Energy Producers Index. “Clean energy themes are still in the early stages of adoption, meaning there is potential for significant growth,” Ruid says. RNRG costs a 0.66% expense ratio.
First Trust Nasdaq Clean Edge Green Energy Index Fund (QCLN)
“We strongly recommend using clean energy ETFs because it is where we expect to see growth going forward,” says Peter Krull, partner and director of sustainable investing at Earth Equity Advisors. “It’s important to remember that industries like solar and wind do not fall under the traditional ‘energy’ sector, so if you buy a fund like XLE, you will only own fossil fuels and not clean energy,” Krull says.
A good pick for broad clean energy exposure is QCLN, which tracks the Nasdaq Clean Edge Green Energy Index. The index deploys a screener to target companies involved in the following clean energy themes: advanced materials, energy intelligence, renewable electricity generation and renewable fuels, and energy storage and conversion. QCLN charges a 0.58% expense ratio.
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7 Best Energy ETFs to Buy Now originally appeared on usnews.com
Update 03/13/23: This story was published at an earlier date and has been updated with new information.