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March 01, 2002 at 07:00 PM
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.
