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Investor Resource Guide: Energy ETFs

By Shelly K. Schwartz,|Special to CNBC.com
Friday, 20 Jun 2008 | 3:52 PM ET

Not long ago, the volatile energy sector was dominated by institutional investors. With fewer resources and a limited grasp of the complex world of commodity trading, it was hard for retail investors to play the oil patch – beyond picking stocks that appeared positioned for growth.

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How times have changed.

As the energy bull market rages on, individual investors looking to ride the rally in oil and gas (and alternative energy) need only select from the dozens of energy-oriented Exchange Traded Funds (ETFs) that are cropping up to meet demand.

“ETFs make it easy for retail investors,” says Tom Lydon, president of Global Trends Investments, and editor of ETFTrends.com, an online financial newsletter.

“In the past, if you were going to buy oil you had to buy oil futures," explains Lydon. "Now, you can buy ETFs which trade like a stock so they’re much more liquid and you don’t have to worry about the more sophisticated strategies of futures trading.”

ETFs are a lot like an index fund, offering a diversified basket of stocks that track the performance of a benchmark stock or bond index.

Because they trade on a stock exchange throughout the day, ETFs are favored by active investors looking to profit from short-term fluctuations in the market. (Mutual funds are generally priced only once a day.)

In today’s market, where rising crude oil prices are pushing the cost of gasoline ever higher, Lydon notes energy ETFs offer some consolation for individual investors.

“Energy-based ETFs have become a great way to hedge your portfolio against what you pay at the pump,” he says. “If the price of gas hits $5 [a gallon], but you’ve got part of your portfolio making money because of the rising prices, there’s a bit of an offset there – emotionally and financially.”

Here’s a look at the major groups of energy-oriented ETFs available.

Diversified Funds

Investors who are looking to get into energy, but are still learning the ropes, would be wise to start with a well-diversified (and less volatile) ETF that invests in companies engaged in the exploration, production and marketing of oil, natural gas and coal, says Jeff Ptak, ETF analyst for Chicago-based fund tracker Morningstar.

“The more diversification the better when we’re talking about funds that invest in energy stocks,” says Ptak.

Vanguard Energy ETF, for example, invests in all major energy sub-sectors. Others in the group include the widely traded Energy SPDR, which tracks the performance of the S&P Energy Sector Index. Its top holdings include Exxon Mobil, Chevronand ConocoPhillips.

Targeted Funds

Those who already have exposure to energy, and have a bigger appetite for risk, can be more targeted in their approach, buying ETFs that focus on a particular sub-sector, such as oil exploration. Such funds, however, are more prone to sharp swings, since their fortunes rise and fall with changing commodity prices.

“Oil services and equipment-makers, in particular, are quite sensitive [to commodity price fluctuations],” says Ptak.

As their name implies, for example, funds like iShares Dow Jones Oil and Gas Exploration invest only in companies engaged in the exploration for and extraction, production, refining and supply of oil and gas products, while iShares Dow Jones Oil Equipment invests in companies that supply equipment and services to oil fields and offshore platforms.

If you’re planning to buy more targeted ETFs, Ptak notes you should stick with funds that include larger, more established companies. “Most of them follow large-cap indexes already, but I would tend to skew towards larger, higher quality names if you don’t have an enormous risk tolerance,” he says.

Alternative Energy Funds

There are also a handful of more narrowly focused ETFs that invest exclusively in clean energy companies or products that use renewable sources of energy (unlike fossil fuels) such as solar, wind and geothermal.

Among them are Market Vectors Environmental Services, First Trust NASDAQ Clean Edge, Van Eck Global Alternative Energy , PowerShares WilderHill Clean Energy, PowerShares WilderHill Progressive Energy , PowerShares Cleantech Portfolio and Claymore/LGA Green and Claymore/MAC Global Solar Energy Index .

Alternative energy ETFs, however, are more volatile still, since the companies they invest in are typically smaller, upstart firms that have yet to establish themselves in this rapidly evolving marketplace.

Commodity-Based Funds

Another category of EFTs invest directly in oil and gas commodities, including crude oil and products made from it, such as gasoline and home heating oil. Commodity ETFs either own the actual commodity in storage, or purchase them through futures contracts.

Among them are United States Oil Fund , which tracks the futures prices of West Texas Intermediate light sweet crude oil, and PowerShares DB Energy Fund, which tracks the price of two grades of crude oil, heating oil, gasoline and natural gas.

Others include United States Gasoline and iPath S&P GSCI Crude Oil Total Return Index.

Again Ptak cautions individual investors to take a measured approach when buying commodity ETFs or exchange traded notes (ETNs), which are not funds at all but 30-year debt securities which track the major indexes.

“Average investors should not be buying single commodity vehicles,” he notes. “They are highly volatile and it’s extremely difficult to suss out the supply and demand dynamics of an individual market.”

His reccomends investors “focus on baskets of commodities to spread your bets a little” and reduce volatility.

For The Bears

Not surprisingly, the flood of new offerings has also spawned a few bear funds designed to profit from a downturn in energy prices. They include: Rydex Inverse 2X S&P Select Sector Energy fund, ProShares Short Oil & Gas and ProShares and ProShares UltraShort Oil & Gas.

While these funds make it easy to hedge your portfolio against any downturn in the energy sector, bear funds are better left to more sophisticated, tactical investors who are looking to profit from short-term swings in the market.

“If you feel that we’re in the midst of a bubble and you believe a major correction in energy prices is near, bear ETFs might be able to help alleviate some of that pain, but average investors should really be taking it one step at a time,” he says. “These are not something you just buy and walk away from.”

Keep It Balanced

Despite the staggering performance of all things energy over the last few years, Ptak urges individual investors to keep their exposure to the sector relatively small, noting energy stocks make up less than 15 percent of the S&P 500.

“If you’re allocating upwards of that amount of your portfolio assets in energy, you’re putting a bet on it,” he says. “More aggressive investors would be at the higher end of that spectrum, while more conservative investors should be well south of that mark.”

If you’re ready to retire, or have a more limited investment time horizon, you may want to avoid the sector altogether. “I wouldn’t think anyone approaching retirement, for example, would not want to lean way out on their skiis like that and make a big bet on the oil patch,” says Ptak.

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