Exchange-traded funds enable investors to reach into nearly every corner of the market with a single convenient and diversified U.S.-traded security. Energy equities represent one of these corners of the market, where it’s important to remain diversified given the volatility present in many of the underlying commodities moving the market. Fortunately, there are many ETFs that are uniquely suited to help investors build exposure into their portfolios .

What’s The Appeal?

The energy sector represents an extremely important portion of the U.S. economy, particularly as the U.S. is the second largest energy consumer in the world behind China. For investors, the boom in hydraulic fracturing has also brought a lot of attention to the industry, with the potential for the U.S. to become energy independent by 2030 and export oil abroad by the year 2035, according to the U.S. Energy Information Administration (“EIA”).

Investors seeking exposure to this sector may find that ETFs offer key advantages over purchasing equities individually. In addition to the benefits of diversification, ETFs provide investors with greater liquidity than may be possible in many smaller energy equities, including many American Depository Receipts (“ADRs”) traded on U.S. exchanges. These ETFs also target a broad array of equities, making it possible to invest in many corners of the energy market .

Watch Your Big Oil Weight

The problem with many energy ETFs is that they are weighted based on market capitalization, which means that large oil companies often account for an oversized portion of overall holdings. For example, the Energy Select Sector SPDR holds roughly 17% of its portfolio in Exxon Mobil (XOM) and 15% of its portfolio in Chevron (CVX). These oversized holdings add company-specific risk and overweight exposure to big oil to an individual’s overall portfolio.

Investors looking to avoid this type of exposure can purchase ETFs that utilize different stock selection methodologies. For example, the First Trust Energy AlphaDEX Fund ETF selects energy stocks from the Russell 1000 Index based on growth factors, like stock price appreciation, price-to-sales ratios, and one-year sales growth. While these may not be weighted according to market capitalization, they may be far more diversified than other options .

Here’s a comparison between some various energy ETF options (data as of 10/30/13):

Ticker Symbol ETF Name Largest Allocation (%)
XLE Energy Select Sector SPDR Exxon Mobil (17%)
VDE Vanguard Energy ETF Exxon Mobil (22%)
PXI PowerShares Dynamic Energy Sector ETF Noble Energy (2.7%)
RYE Rydex S&P Equal Weight Energy ETF Newfield Exploration Company (2.5%)

Going Beyond Oil

Crude oil represents the largest portion of the energy market, which means that many energy ETFs are dominated by oil-related stocks. Investors looking for exposure elsewhere in the energy market have numerous options in solar energy, wind energy, natural gas, or coal, as well as equipment and service companies that aren’t necessarily tied to the price of oil, including engineering and consulting firms that act as advisors or suppliers to the industry .

Some popular alternative energy ETFs include:

  • PowerShares WilderHill Clean Energy ETF – With $217 million in total assets and a 0.7% expense ratio, the ETF invests in companies that focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy.
  • Market Vectors Oil Services ETF – With $1.7 billion in total assets and a 0.35% expense ratio, the ETF invests in the 25 largest U.S.-listed, publicly traded oil services companies, including names like Halliburton Co. (HAL).
  • Market Vectors Global Coal ETF – With $176 million in total assets and a 0.59% expense ratio, the ETF invests in companies within the coal industry, including names like Joy Global Inc. (JOYG) and Consol Energy Inc. (CNX).
  • First Trust ISE-Revere Natural Gas Index ETF – With $540 million in total assets and a 0.6% expense ratio, the ETF invests in natural gas stocks, including names like Noble Energy (NBL) and Goodrich Petroleum Corp (GDP).

Going Global

Investors in the energy sector may also want to diversify their exposure around the world, instead of focusing exclusively on the United States. While energy is largely a global commodity, U.S. based firms can be affected by a number of domestic-only issues, including increased governmental regulation, tariffs, or other risk factors. Diversifying internationally can help allay many of these concerns and improve risk-adjusted returns across the board .

Some popular global energy ETFs include:

  • iShares S&P Global Energy Sector ETF – With $993 million in total assets and a 0.48% expense ratio, the ETF invests in energy companies around the world with only about 50% weighting in the U.S. and about 15% exposure to Exxon Mobil (XOM).
  • SPDR S&P International Energy Sector ETF – With $13 million in total assets and a 0.5% expense ratio, the ETF invests in non-U.S. energy companies, including names like BP plc (BP), where it holds about 11% of its total value.

The Bottom Line

Investors have many options when it comes to investing in energy ETFs, but the four considerations in this article should help narrow the field. By being mindful of weightings and expense ratios, investors can avoid unexpected problems, while considering alternative sub-sectors and international companies can help improve diversification.

Disclosure: No positions at time of writing.

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