There’s something strange happening with energy ETFs. Here’s what you need to know

Published Fri, Apr 22 202210:16 AM EDTUpdated Fri, Apr 22 202210:38 AM EDT

Jesse Pound @/in/jesse-pound @jesserpound

The energy industry has been one of the few bright spots for investors this year, but there has been some weird activity under the surface of one of the sector's flagship exchange traded funds. Todd Sohn, a technical and ETF strategist at Strategas Securities, highlighted the recent massive outflows from the $39 billion Energy Select Sector SPDR Fund (XLE) despite solid performance for the underlying stocks. "The fund posted a record outflow in March (over -$2 Bn), creating an interesting divergence between sentiment ('the rally is over') and the market's interpretation ('Energy is leadership'), that we believe deserves attention," Sohn wrote in a note to clients on Tuesday. In April, the major outflows from the XLE have stopped but the net inflows have been meager. Still, the fund is up more than 10% since the end of February. ETFs trade like stocks, with individual investors able to buy and sell outstanding shares. But larger investment firms will also create or redeem shares in the fund, which comprises the flows. The XLE was not alone among major funds in the sector seeing flows that differ from performance. The Vanguard Energy Fund (VDE) also saw negative flows in March, according to FactSet, though they were less dramatic. The SPDR S & P Oil & Gas Exploration & Production ETF (XOP) was positive for the month overall but did see withdrawals in the final two weeks of March. The divergence between performance and flows can be viewed in different ways. The outflows could be a sign that demand for oil stocks is weakening or that there is still room for it to go higher still, despite the strong start to the year. Sohn takes a more favorable view for the sector, seeing the potential for energy to head back toward its historical average weight in the S & P 500 after declining over the past decade. "At a minimum, we'll chalk this up as supportive from a contrarian view, but we'd rather see outflows accompanied by a proper flush in price internals – stay patient," Sohn wrote. To be sure, fund flows are not a perfect way to judge investor sentiment toward individual sectors. Zach Hill, head of portfolio management with Horizon Investments, said that ETF flows provide an important but imperfect view of investor sentiment. "ETF flows only capture one particular portion of the market. So if you're looking at them in isolation, they may not be telling the whole story. That flow coming out of the ETF could go to another ETF, it could go to a mutual fund, it could go to all sorts of other vehicles that may or may not impact the underlying stocks," Hill said. Another factor that can muddy the waters is the derivatives market. Big sector ETFs are a popular way for investors to make calls on macro trends, and heavy options trading on a fund can distort the flows. "Especially in the bigger or more liquid ETFs that have a lot of underlying options trading going on with them, that trading can show up as inflows or outflows, creates or redeems, as dealers hedge those underlying options positions," Hill said.

An oil pumpjack pulls oil from the Permian Basin oil field on March 14, 2022 in Odessa, Texas.

Joe Raedle | Getty Images

The energy industry has been one of the few bright spots for investors this year, but there has been some weird activity under the surface of one of the sector's flagship exchange traded funds.