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Energy Part 2: ETFs and Mutual Funds

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In today’s challenging markets, many investors are turning to sector investing. The energy sector may be a good place to begin for two reasons.

First, energy is a necessity of modern life. Second, the energy sector has been beaten down over the past year. For example, the price of crude oil is down over 50% from its June 20, 2014 peak. A collapse of this magnitude is often considered a significant opportunity for investors. However, before you dive in, it would be prudent to understand the different types of energy investments and their associated risks. Last month we discussed the role of energy in society. In this article we’ll look at investing in energy using ETFs and mutual funds.

Overview

When selecting an energy ETF or mutual fund, a good first step would be to choose an energy category. According to Morningstar, Inc., there are three categories for energy ETFs and two for mutual funds. Then, you could choose between an active or passive fund.

Energy Categories

Commodities Energy

Commodities Energy portfolios invest in oil (crude, heating, and gas), natural gas, coal, kerosene, diesel fuel, and propane. Investments can be made directly in physical assets or commodity-linked derivative instruments.

Equity Energy

Equity Energy portfolios invest primarily in equity securities of U.S. or non-U.S. companies who conduct business primarily in energy-related industries. This includes, but is not limited to companies in alternative energy, coal, exploration, oil and gas services, pipelines, natural gas services, and refineries.

Energy Limited Partnership

Energy Limited Partnership funds invest a significant amount of their portfolio in energy master limited partnerships. These include, but are not limited to, limited partnerships specializing in midstream operations in the energy industry (more on this in a moment).

The first category is the most unique in that it invests in the physical commodity or in commodity-linked derivatives. In the Equity Energy and Energy Limited Partnership categories, the target investments are similar, however, the tax treatment varies. Moreover, the target companies of the latter categories can be divided as follows:

  1. Upstream
  2. Midstream
  3. Downstream

Upstream companies are engaged in the exploration and production of energy resources. This includes companies that drill for oil, mine coal, and extract other energy resources. Midstream companies are those involved in the transportation or storage of the commodity. They don’t actually own the commodity, but earn a fee on the amount they transport through their pipeline system or hold in storage. Downstream companies sell the product to the user. It’s worth noting that the majority of Master Limited Partnerships operate in the energy sector and the vast majority of MLPs consist of midstream companies. For reasons that extend beyond the scope of this article, midstream companies have found the pass-through nature of the MLP structure especially appealing. Since each category differs, in terms of strategy and target investment, their risk profiles vary greatly.

Energy ETFs

In a previous article (from the Under the Hood series), I wrote about the five different ETF structures. To read the article, click here. The following tables contain the average data for each category over the periods referenced. The most volatile category has been Commodities Energy, with nearly 30% more volatility than the Equity Energy category and almost 80% more volatility than Energy LPs. Using the Sharpe Ratio to measure the amount of return generated per unit of risk assumed, the Energy LP category has provided the best risk-adjusted returns. Interestingly, it also sports the highest average expense ratio of the three. The Commodities Energy category has had the toughest time, with negative average returns in the trailing three and five-year periods as well as in five of the past eight calendar years.

ETF: Energy Category Overview (as of June 30, 2015)

 

 

 

Standard Deviation

Sharpe Ratio

Mean Return

Expense Ratio 2

Category

# ETFs

Beta 1

3 Yr

5 Yr

3 Yr

5 Yr

3 Yr

5 Yr

 

Commodities Energy

21

1.22

24.88

26.13

-0.41

-0.29

-12.16

-10.72

1.02

Equity Energy

25

1.44

19.32

24.53

0.21

0.36

1.28

5.66

0.47

Energy LP

20

0.80

13.86

14.53

0.49

0.82

5.64

11.55

1.61

1 Relative to each categories Standard Index

2 Gross Expense Ratio

 

ETF: Energy Category Average Returns by Calendar Year

Category

2007

2008

2009

2010

2011

2012

2013

2014

2015 1

Commodities Energy

46.45

-45.52

11.23

-6.09

-7.08

-8.33

4.25

-37.09

-0.45

Equity Energy

36.45

-48.18

42.39

14.71

-13.27

-0.86

23.20

-18.42

-4.65

Energy LP

 –

 –

34.86

12.01

2.45

26.69

3.98

-9.22

1 Through 6-30-15

Energy Mutual Funds

While ETFs offer intraday pricing and, in general, a lower expense structure, mutual funds have been quite competitive in this space. For example, the average energy-based mutual fund has outperformed the average energy-based ETF in absolute terms and on a risk-adjusted basis. The mutual funds have also achieved this with a lower standard deviation as evidenced by their higher Sharpe Ratios. Despite having an edge in risk and return, because mutual funds operate with end-of-day pricing, investors may prefer the intraday pricing of ETFs. One notable difference is the gross expense ratio. In the categories common to both groups, mutual funds have a much higher average expense ratio than ETFs.

Mutual Funds: Energy Category Overview (as of June 30, 2015)

 

 

 

Standard Deviation

Sharpe Ratio

Mean Return

Expense Ratio 3

Category

# MFs 1

Beta 2

3 Yr

5 Yr

3 Yr

5 Yr

3 Yr

5 Yr

 

Equity Energy

28

1.34

17.50

23.43

0.27

0.30

3.07

4.40

1.71

Energy LP

28

0.60

9.94

9.19

0.99

0.93

9.86

8.51

4.91

1 Number of different funds, not share classes

2 Relative to each categories Standard Index

3 Gross Expense Ratio

 

Mutual Funds: Energy Category Average Returns by Calendar Year

Category

2007

2008

2009

2010

2011

2012

2013

2014

2015 1

Equity Energy

42.09

-51.12

44.36

17.14

-7.54

1.21

22.85

-16.65

-2.77

Energy LP

 –

 –

 –

 –

6.64

4.09

23.24

7.93

-3.96

1 Through 6-30-15

Is it better to buy an energy-based mutual fund or ETF? It depends. The data in the tables above only tell part of the story. It’s also important to understand the dispersion of the returns. For example, the best performing mutual fund in the Equity Energy category returned 61.54% in 2013. The next best performer returned 38.01%. In 2014, the best performing ETF in the same category returned 23.83% while the second best lost 8.70%. Equity Energy’s worst performing ETF that year was -41.89%. In short, there is often a wide variance between the best and worst performers.

We have just discussed some of the characteristics of investing in energy using mutual funds and ETFs. We also explored the difference between upstream, midstream, and downstream companies. Next time we’ll look at energy investing using individual stocks and MLPs. We’ll also examine performance, risk, and a host of other useful statistics. Stay tuned as we drill down (pun intended) into the numerous industries that comprise the energy sector.

– Related from Mike Patton: What You Need to Know Before Investing in Energy

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