It’s hard to ignore all the noise surrounding energy stocks these days.
Oil companies are posting record profits, thanks to the sharp and prolonged run-up in crude oil prices.
Companies that market clean energy products are reaping the rewards of global environmental awareness and increased cost competitiveness.
Indeed. The energy companies that help comprise the S&P 500 index have posted an eye-popping 26.8 percent compounded annual growth rate over the last five years.
"The energy and general commodity sectors are both red hot at this point and have been since 2003," says Michael Herbst, energy analyst for Chicago-based fund tracker Morningstar. "Some of the rosy prospects for these companies have already been priced into the stock, which investors should be aware of, but the supply and demand dynamics driving energy stock price gains still seems to be a long ways from playing out."
With the proliferation of energy-oriented mutual funds over the last ten years (as well as the growth of similarly-based Exchange Traded Funds Funds more recently), getting a piece of this supercharged, if highly volatile, sector has never been easier.
More than 50 energy funds, often referred to as natural resource funds, are available to investors today, offering a diversified basket of stocks engaged in oil exploration and production, oil services and equipment, natural gas, and coal, along with energy-saving devices.
"The importance of professional management in a sector like this can’t be overstated," says Herbst. "These managers have a deep expertise and understanding of the inner workings of the companies they invest in. They’re familiar with the spikes and swoons in the energy sector so they’re able to keep a more steady hand on the portfolio than individual investors might be able to do."
Hot And Cold
To be sure, energy funds are notoriously hot and cold—evident in their high standard deviation values, a measure of how widely fund returns fluctuate over time.
The energy funds in Morningstar’s natural resources category, for example, have an average standard deviation value of 22.8 percent over the last 15 years. The stocks that comprise the S&P 500 index, by comparison, have a much lower average standard deviation of 13.7 percent.
Part of the reason for the sector’s yo-yo performance is that a large percentage of the world’s oil reserves are located in somewhat unstable countries.
Mutual funds, especially those that maintain a diversified portfolio of stocks, can help offset some of that volatility.
"Mutual funds are a diversification tool used not only to lower risk, but to help investors avoid putting all their eggs in one dangerous basket," says Michelle A. Smith, managing director of the Mutual Fund Education Alliance in Kansas City.
What’s Out There?
There are two main categories of energy-based funds, from which to choose.
Traditional funds, including Vanguard Energyand Guinness Atkinson Global Energy, invest in a broad cross-section of oil and gas companies engaged in the production or transport of oil and natural gas, equipment manufacturing and energy conservation.
Many target large-cap oil and gas companies with access to the world’s most proven oil reserves such as Exxon Mobil, UK-headquartered BP,and Chevron, along with oil and gas exploration firms such as Occidental Petroleumand oilfield services providers like Schlumberger.
Each fund manager, of course, sets his own strategy when it comes to picking stocks. Some target mid-, or small-cap companies, while others focus on stocks positioned for growth or those that are viewed as underpriced (value stocks).
When it comes to the oil patch, however, Herbst advises individual investors with a lower tolerance for risk to stick with large-cap funds.
"Funds that focus on smaller cap energy firms are much more likely to be volatile over the long haul because smaller producers are involved in production of only one commodity (like coal) so their fortunes rise and fall with the price of coal," he says.
Smaller energy companies may also have exploration projects on their plate that are only possible when commodity prices are high.
"When prices rise those smaller firms typically get a bigger boost than the larger firms, but that’s a door that swings both ways," says Herbst. "When prices drop, they take it on the chin much harder than the Exxons and ConocoPhillips of the world."
Mutual fund screeners available online, including CNBC’s, enable investors to view a complete list of energy funds in the natural resources category, along with their performance data and expense ratios.
Morningstar’s also provides a breakdown of the fund’s top five holdings and the manager’s investment style.
Clean Energy Funds
The other broad category of funds in the rapidly evolving sector are those that invest in renewable energy and related technologies, including wind, solar, hydropower and geothermal.
They include the New Alternatives fund, Guinness Atkinson Alternative Energy , and Calvert Global Alternative .
"We’ve been seeing more and more alternative energy funds launch over the last year, but investors should be aware that the expectations and risk level of these funds are different than they are for traditional energy funds," says Herbst.
"Many invest in solar or wind power or biofuels and, with the exception of larger solar and windpower firms, most companies are still early-stage, small-cap companies which may be riskier than larger caps," he adds.
For the first half of 2008, this sub-sector is largely in the red, partly because of tough year-over-year comparisons, but also because many investors sought to curb their exposure to riskier stocks amid the market turmoil in late 2007 and early this year.
Unfavorable governmental decisions abroad have also shaken investor confidence in continued support for biofuels and solar power, says Herbst.
The Twain Shall Meet
Though alternative energy funds and traditional energy funds remain firmly entrenched in different camps, there are a few fund managers who are starting to blend the two.
Fidelity Select Energy and BlackRock Global Resources, for example, are adding a small number of clean energy stocks to their line-ups. "These are diversified funds that see the value in alternative energy so investors are starting to see a number of those stocks in those funds as well," says Herbst.
Before buying any mutual fund, be sure to consider its expense ratio, the percentage of the fund’s assets used to pay for management and operating fees.
According to Morningstar, the median expense ratio for its natural resources category is 1.31 percent, though some actively traded funds are well above 2 percent. The higher your expenses, the lower your return.
You should also look closely at the equities you already own, including the top holdings in your 401(k). Many large-cap funds (growth and value alike) have been upping their investment in energy stocks over the last five years.
"We urge investors to take a look and see where they have energy exposure already," says Herbst. "You may already have meaningful exposure through some of your large cap funds."
There’s no one-size-fits-all formula, but Herbst adds most investors should allocate no more than 5 percent of their total portfolio towards energy stocks.
"It’s tempting right now to chase gains, but an asset allocation approach to the sector is a good idea," he says.
Keep an eye on your portfolio and trim back your energy exposure to 5 percent (or your own target percentage) when it starts to climb.
"It takes some willpower to do that, but sticking with your original allocation rather than trying to play the sector is the way to go."