Know What You're Getting With Energy ETFs

Todd Shriber
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ETFs have taken their lumps lately as more than a few pundits have chided this asset class as a culprit for May's ''flash crash.'' Other common knocks against ETFs include the love affair hedge funds seem enjoy with these products, ETFs have led to increased market correlation, making it harder to pick stocks, and ETFs have had made the market more volatile. All of these points are up for debate, but I want to address the curious world of energy sector ETFs.

It always pays to know what exactly your investment dollars are buying you and that sentiment is especially true with energy ETFs. The first useful factoid is this: Exxon Mobil (XOM) and Chevron are the second- and fifth-largest stock components by dollar amount held across ALL U.S. ETFs. Only one other oil-related stock, Schlumberger (SLB), cracks the top 25.

Of course, Exxon and Chevron are the two largest U.S. oil companies, so their dominant presence in the ETF world is not surprising, but it is something investors need to be aware of when shopping for an energy ETF. Just because someone wants exposure to the oil industry does not mean he wants exposure to Exxon or Chevron (CVX).

And if you want to take a pass on those companies, it would be wise to take a pass on the Energy Select Sector SPDR (XLE), the iShares Dow Jones U.S. Energy Sector Index Fund (IYE) and the Vanguard Energy ETF (VDE). That is not to say these are bad funds, just be aware that Exxon and Chevron combined account for over a third each ETF's weight.

Do not think that the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) will get you away from the top-10 holdings of the three aforementioned ETFs. All XOP does is shift the weights of Exxon, Chevron, Apache, Anadarko, etc. around and add a few smaller names not found in the likes of XLE or VDE.

Speaking of Apache (APA) and Anadarko (APC), if you're interested in both of these names and cannot decide between the two, finding an ETF that will give you decent exposure to both names is a hard task. Of the ETFs I looked at that have decent daily trading volume, only the iShares Dow Jones U.S. Oil & Gas Exploration & Production Index Fund (IEO) gets you involved with Apache and Anadarko to any noteworthy degree and still the exposure is slight with 9.2% to Apache and 7.5% to Anadarko, respectively. In other words, if you really want to participate in upside for either of these names, it might be best to own them outright.

Same goes for Transocean (RIG), the world's largest provider of offshore drilling services. One would think that the world's largest provider of anything would be well represented in plenty of ETFs. That is not the case. The only ETF to allocate a double-digit weight to Transocean is the Oil Services HOLDRs (OIH), so if you want in on capital appreciation with this stock, it is probably best to just own the shares. And do not think it is possible to mitigate the volatility in Transocean by investing in the Switzerland-specific ETF. Yes, Transocean is based in Switzerland but the corresponding ETF offers no exposure to the company.

And again, the same lesson can be applied to BP (BP). According to the trading blog, prior to the Gulf of Mexico oil spill, only three somewhat liquid ETFs focused on international energy companies offered exposure to BP. Post-spill, only one offers double-digit exposure to the British oil giant while one of the other two has expelled BP altogether.

The moral of the story is simple: Do your homework before buying an energy ETF and consider options or owning stocks of companies you like over ETFs.