March 1, 2002

Energy Boost

Enron notwithstanding, we look for signs of life i

In the early stages of an economic recovery, energy stocks deserve a thorough look, but the jury remains out on whether they're a buy-and-hold group. For income-seeking clients, the dividend story holds up. For long-term growth investors, the fact that they're cyclical and commodity-based lends them to the trading side of a portfolio's balance sheet. Moreover, owning energy stocks isn't as simple as owning the major oils; as with gold, where mining stocks are the lucrative stakes, energy service stocks are where the real money can be made or lost.

A number of energy stocks have been in the news of late, but recent news has not generally been good. After a great 1999 and 2000 in which oil was immune to silicon's weakness, 2001 saw mostly middling returns, with September 11 and a recession leading to reduced prospects for demand and reduced share prices.

And then there's Enron. Of course, the real solution to Enron employees' problems would have been diversification. (To be fair to Enron employees, this was not so easy in their 401(k) plans; to be fair to Enron, it was providing free shares to those employees.) It's also a good idea to look over the corporate books before buying a stock, but in the end, nothing is as effective at reducing risk as diversification. Which brings us to Standard & Poor's Energy Select Sector SPDR, which trades under the symbol XLE.

The Select Sector SPDRs can include foreign stocks and ADRs. But they do have a domestic emphasis; all of their stocks are in the S&P 500, with each of the 500 stocks held in one, and only one, of the nine Sector SPDRs. After the stock allocation, ETF initial positions are generally made at approximate market cap weighting. Among other things, these facts mean that (1) no active management principles are used, except insofar as the S&P 500 index is itself so managed (and it's primarily just looking at market cap) and (2) some conglomerates have to be, somewhat arbitrarily, put in one category or another, based on their largest sector representation.

Companies in the S&P Energy index develop and produce crude oil and natural gas, and provide drilling and other energy-related services, but this market capitalization-weighted index is dominated by a few giant, multinational oil firms.

Why Energy?

First, energy stocks are a relatively stodgy, low-beta part of the market. They generally feature below-market price/earnings levels. In short, holding a portion of a stock portfolio in energy stocks is likely to reduce total portfolio volatility or risk.

Energy stocks also pay above-average dividends. Not that "above-average" is all that high in this market, but they are in many cases higher than short-term interest rates.

And energy stocks are a lot more interesting than bonds and cash, offering the prospect for long-term growth. While 2001 was weak, the stocks performed outstandingly in 1999 and 2000 as technology and other growth sectors were falling apart, and even some value plays got squeezed. (The Energy Select Sector's share price gained 16.0% in 1999 and 22.6% in 2000, then fell 19.7% in 2001; add almost 2% in dividends to get total returns, and you're way ahead of the market and most other sectors.)

Stock Positions

Unlike some other ETFs, such as the Biotechnology HOLDR covered last month, the legal structure of the Sector SPDRs is such that they won't tend to shrink in terms of number of holdings. (The nine broad sectors altogether should always have 500 positions.) However, energy is a field that's seen quite a few mergers over the past several years--the product of almost two decades of relatively lean times and broader reorganization across a wide variety of mature industries.

The S&P Energy Select Sector SPDR had 30 positions as of September 30, 2001. But Enron was booted last year as that firm's stock collapsed and dropped out of the S&P 500 on November 29. (Dynegy cancelled a deal to purchase Enron on November 28, and Enron filed for Chapter 11 bankruptcy on December 2.) And the ChevronTexaco merger brought the number of stocks in the SPDR down to 28 by the end of 2001.

That should be plenty to endure diversification, although the nature of market-cap weighting means a few positions will be outsized. The SPDR's top holding, Exxon Mobil, recently accounted for 23% of assets. It's followed by Royal Dutch Petroleum at 15% of assets, with the next four holdings--ChevronTexaco, Schlumberger, Phillips Petroleum, El Paso--each making up just over 4%.

Lessons of Enron

Naturally, the Energy Select Sector fund suffered virtually all of Enron's decline. (This is just as true, although with a smaller position, of S&P 500 index funds.) But the fund's diversification meant the damage was limited. At the end of September, when Enron was still selling for $27.23 per share, it amounted to 3.4% of the fund. At Enron's peak, it had been north of 8% of the index early in the year, so ill-timed investments in the fund certainly saw some damage, but few individual stock investors who held any Enron at all in early 2001 kept the stock to just 8% of the energy portion of their holdings.

Upshot: The level of diversification in the Energy Select Sector SPDR made a big difference to portfolio risk, and perhaps a bigger difference to what an investment advisor might call "client risk." How many clients have been, or are about to be, lost due to the presence of "Enron" on a statement? In contrast, how many clients have blamed a manager for holding a bad stock within an index position? Naturally, total portfolio return ought to be the name of the game, but in reality an Enron can damage your relationship to a client even when the big-picture numbers look good.

If you trade individual stocks, there are presumably sectors or stocks where you feel comfortable with the industry, the story, and the accounting. But few of us can really keep on top of every sector. Where that's true, an ETF can prevent a world of trouble.

ETF Trading

Like other ETFs, the S&P Energy Select Sector SPDR is basically a low-cost index fund that trades like a single stock, with market prices generally very efficient, close to the net asset value of the underlying holdings. For the fund, the bid/ask spread is generally under 0.3%, so the total round-trip cost is about 0.3% plus two stock commissions. With $20 trades, that comes to 0.5% total on $20,000.

There are two much smaller competing ETFs that are invested in energy stocks. The iShares S&P Global Energy Sector Index Fund (IXC) invests globally. Holdings include oil equipment and services, oil exploration and production, and oil refineries. The fund holds 45 stocks, including BP Amoco, Total Fina, and Shell, which are not in the S&P Energy Select Sector SPDR. The iShares Dow Jones U.S. Energy Sector Index Fund (IYE) invests in U.S. energy stocks. Its 56 holdings include coal producers and pipeline companies as well as a wide variety of oil-related firms. The fund does hold El Paso; its most notable omission is foreign giant Royal Dutch. And, then there's the Rydex Energy fund, an actively managed sector fund. While Rydex offers two sector funds in the energy arena (one that focuses on major oils and the other on energy service stocks), they're not alone. Fidelity offers a wider range of actively managed energy sector fund options, and Vanguard offers one.


Mutual Fund

A Pumped-Up Index Fund?

An interview with Dan Gillespie, manager of Rydex's energy sector fund

Rydex has a unique universe of actively managed sector funds. I say "unique" to capture not only its take on how a sector fund should be constructed, managed, and priced, but to also raise one eyebrow about its methodology. Unlike Fidelity's Select funds, Invesco's Sector funds, or Vanguard's Specialized funds, where active management rules the portfolio's roost and performance is the marketable security, Rydex's pitch has an index-fund-like crow about it, but that doesn't mean you should cackle at it. It does mean that you need to know that at Rydex, the majority of the sector fund portfolios are pieces that, when glued together, form a near mirror-image of the index the sector fund tracks. There is one piece missing: the actively managed component that accounts for approximately 5% to 10% of the portfolio's composition.

The advantage? Cost. More efficient and lower pricing versus owning the stocks outright or versus paying a 3% front-end load for a Fidelity Select fund, for example. The disadvantage? Performance. Fidelity Select Energy, for example, significantly outperformed the Rydex Energy fund (RYEAX) in the boom years of 1999 and 2000, and lost less in 2001. The S&P Energy Select Sector fund, on the other hand, gained less and lost more during the same time period. That fact alone lets manager Dan Gillespie pipe up on Rydex Energy, but it's still a tough sell.

What is Rydex's sector fund philosophy? We have 17 different sector funds, and our philosophy for all of them is basically the same. What we try to do is to provide investors with a pure play in a particular sector. We also want to provide our clients with liquidity, because we do allow our investors unlimited exchanges with no fee.

And another thing, we're always fully invested. We examine an entire universe of stocks; take the energy sector, for example. First of all, we do a liquidity analysis to make sure that these stocks are liquid and tradable. We then look at the stocks and make sure they're correlated, make sure there's similarity. At that point we come up with what we consider to be an investable universe. Then, we optimize the portfolio. We have an optimization model that basically provides us with the best combination of liquidity and similarity to provide a vehicle with the least amount of market impact on trading. What we come up with is a very liquid trading vehicle that best represents a particular sector.

How do you distinguish yourself, say, from the S&P Energy Select Sector fund (XLE)? Well, we've done studies in the past and we feel that we may be a little bit more liquid than the ETFs, and we think we're in a more efficient vehicle as far as trading.

Are you dramatically overweighting the top 10 holdings? It's a modified cap weight. The ETFs--I haven't really looked at them lately, but they probably own a little bit more, and probably a lot more, than we do, say, in Exxon. We don't own more than 20% of any one stock. In the case of an Exxon, which is about 40% of the sector, we wouldn't own that much. We currently own 72 stocks (we also own ADRs in our portfolio). We have a Web site where investors can look at their holdings online. We give them to you every day. A financial advisor can visit the site and see exactly what the weightings in our fund are on a daily basis.

If one were comparing the Rydex Energy fund to the Fidelity Select Energy fund, that would be a profound difference. What process determines the number of holdings and the weightings within those holdings? It's our optimization model, which is basically a market-impact model. That's pure and simple. We're trying to provide an instrument that is tradable with the least amount of market impact.

We use what we call an active quantitative approach toward building these sectors. We look at different factors in each sector that have affected the performance of stocks in the past, and which slightly tilt the portfolio depending on these factors. For example, right now I have a value tilt, a slight overweighting, on the energy fund. Right now we're looking at book-to-price, but that changes periodically. We look at a number of different factors in each one of these sector funds. For value we might look at sales-to-market-cap, or PEG [price-to-earnings-growth] ratios, book-to-price. For some quality we might look at return on equity, debt to equity, that type of thing. We also look at some more quantitative factors such as price momentum.

Who created your models, and are those models themselves constantly revised? We have an entire quant department that is constantly looking at different factors that affect all the sectors. We have an investment strategy committee to whom each portfolio manager presents his latest findings or latest strategies that he'd like to implement on the fund. The investment strategy committee reviews it, and we make a decision. It's a team approach.

What's attractive about the energy sector now? Especially now, since the energy sector's gotten beaten down so much, I think it's an area that should be part of everyone's portfolio. I'm not saying right now--it could be a while before these stocks turn around--but if you look at just the macroeconomics of the world, worldwide energy demand is expected to grow 50% in the next 20 years, and there's only so much oil in the world. I think that energy supply is going to have to expand to meet this rise in demand. Today, if you're looking at the short term, it might be a good entry point to get in.

Is the economy going to pick up? I personally believe we're pretty close to a bottom--on the economy that is; I don't know about the stock market. Low oil prices stimulate the economy, so that's one reason I think you're going to see the economy pick up.

I think that another thing you have to beware of is OPEC. They had four production decreases in the year 2000, and they're planning on another one pretty soon, but then again, they cheat on these things all the time. These are things that are kind of hard to put into your model. You have to look at it from a point of view that oil prices right now could go lower, but I don't think they're going to go too much lower, and then again I don't think you're going to see them skyrocketing back up. In the long run, I think this is a pretty good entry level to expose yourself to energy and energy service stocks.

I think there's a lot of good things going on in the industry right now, especially with consolidation and cost-cutting, but I also think that, like anything else, like any sector, you just never know what's going to happen.

Enron is a perfect example. I would not put my eggs in one stock, not even an ExxonMobil or a ChevronTexaco. I would definitely buy a mutual fund to spread my risk. I think that since the Persian Gulf right now is the key or the main oil supplier, that's a problem. In the long run, I think that our country's going to have to expand capacity as far as exploration and production of oil. The Bush administration has started out on that, but it seems to have been put by the wayside. I think that it's important that we're not so dependent on Saudi Arabia for our oil. There are a lot of things that people have to be aware of, but I think in the long run, you're going to see oil prices rise and you're going to see the stock prices rise along with them.

We're always cognizant of risk. We call it a risk budget. And we're looking to build a long-term investment vehicle here without taking any undue risks.

My outlook is that I think in the long run everything is good, but I'm fairly defensive right now because of the state of the world.

Any final thoughts? Our goal is really to outperform the sector in the long run. So we consider this more of a long-term investment, not just a trading vehicle. It just so happens that we allow investors to take advantage of that privilege.

As a portfolio manager, I would prefer that people would stay in the fund. That way I could concentrate on things besides liquidity, and that's the direction we're trying to head here at Rydex.


ETF Holdings

What a Gas!

El Paso appears in both the S&P Energy Sector Select SPDR and the Rydex Energy fund

Both the S&P Energy Sector Select fund and the Rydex Energy fund own Houston, Texas-based El Paso (EP), a holding company with numerous subsidiaries. Post-Enron, owning the former instruments as opposed to the latter one may make your clients sleep better, but that doesn't mean that you shouldn't be rooting around and finding out what makes up the parts of an exchange-traded or sector fund.

El Paso's assets are focused on North America, but it runs (to put it mildly) a large global integrated natural gas business that includes drilling (in the Rocky Mountains, Texas, and the Gulf of Mexico), gas processing, transporting (by a nationwide pipeline system and liquefied natural gas ships and LNG terminals) and marketing arms. In addition, it also has electric and telecommunications businesses.

To begin with, El Paso has real assets, and real businesses with real profits. Natural gas is a growing portion of the energy market, both because it's relatively clean and because North American gas supplies are slated to last a lot longer than crude oil. (El Paso does also produce some liquid crude oil; gas and oil often come up together.)

If there's any industry where business plans are limited by the meddling hand of government, gas piping is it. It should come as no surprise that environmental impact statements are required for laying down new pipe, but approval is also required for replacing, say, a 16-inch pipe with 24-inch pipe along the same right-of-way.

And the Federal Energy Regulatory Commission (FERC) doesn't stop at environmental matters; its authorizing certificates include language that a proposal is in "the public interest" because, for example, it "will help meet the growing electric generation requirements of the Midwest." Otherwise, we might see wasteful capitalists spending $1 to $2 million per mile building pipelines to nowhere, perhaps rivaling Japanese bridge construction in their foolishness.

Another risk concerns the shipping, post-9/11, of liquified natural gas (LNG) on large tankers. It was widely reported that the mayor of Boston, among others, didn't want any LNG deliveries made, given that an exploding tanker would dwarf the effects of an airplane full of jet fuel. After security efforts were redoubled, and with New England (which lacks pipeline capacity) otherwise facing the prospect of people freezing in their houses, the shipments resumed. But of course any serious attempt against an LNG tanker could make the expansion of LNG terminals about as popular as the Yucca Mountain nuclear repository.

At a recent share price of $36, the firm is close to its 52-week low of $31.70, and well short of its high of $75.30. With 510 million shares outstanding, the firm has a market cap of just over $18 billion. How much did the company make last year? Well, you don't need to be an Enron to have two or more widely variant sets of numbers, especially when you're growing and acquiring other firms. (Like most surviving energy firms, El Paso has been acquisitive, acquiring, among others, Crystal Gas Storage and Bonneville Pacific in 2000, and Coastal in 2001.)

The firm's trailing P/E is either 11 times its 2001 earnings of $3.31, or 200 times its 2001 earnings of $0.18. How can that be? Well, on January 31, 2002, El Paso announced that 2001 "pro forma" earnings per share increased to $3.31, up 27% from $2.60 in 2000. Reported diluted earnings per share for 2001, which include merger-related costs, asset impairments, and other non-recurring charges, were $0.18 versus $2.57 in 2000. (By the pro forma measure, next year's mean analyst earnings estimate is $3.44.)

The Bush administration, it was widely believed, would favor a less regulatory approach to energy, due both to broader ideological factors and its Texas/oil connections. But after the Enron debacle, whose accounting opacity has been used as an argument for crackdowns on everything from political contributions to free matching stock in 401(k) plans to electricity deregulation, every aspect of the energy business may become even more deeply politicized. For the same reason Nixon could go to China, it's possible that Bush cannot go very far in reducing energy or environmental regulation.

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