Energy Sector ETFs Could Incinerate Your Savings

by: David Trainer

I rec­om­mend investors avoid all energy sec­tor ETFs. There are no ETFs in the energy sec­tor with an attractive-or-better rat­ing from my method­ol­ogy at New Con­structs. 16 of 17 energy sec­tor ETFs get a Danger­ous rat­ing. None of the ETFs rank bet­ter than the S&P500.

Investors should sell all dangerous-rated energy sec­tor ETFs. The five ETFs below are the worst-rated of all energy sec­tor ETFs:

  1. iShares Dow Jones U.S. Oil & Gas Explo­ration & Pro­duc­tion Index Fund (IEO)
  2. SPDR S&P Oil & Gas Explor & Prod­uct (XOP)
  3. SPDR S&P Oil & Gas Equip & Ser­vice (XES)
  4. Rydex S&P Equal Weight Energy ETF (RYE)
  5. iShares Dow Jones U.S. Oil Equip­ment & Ser­vices Index Fund (IEZ)

Investors seek­ing to out­per­form the mar­ket with expo­sure to the energy sec­tor should invest only in the attractive-or-better rated stocks in the sec­tor. Cur­rently, there are only 13 (out of 192 we cover) energy stocks that earn an attractive-or-better rat­ing. They include Exxon Mobil (XOM) and Chevron (CVX).

Fig­ure 1: Energy Sec­tor – Allo­ca­tion & Hold­ings by Risk/Reward Rating

[Click all to enlarge]

Sources: New Con­structs, LLC and com­pany filings

The energy sec­tor is one of four sec­tors to earn our “dan­ger­ous” rat­ing. For our pre­dic­tive rat­ings on all 10 sec­tors, see our 3Q11 Sec­tor Roadmap report. The “dan­ger­ous” rat­ing for the sec­tor does not nec­es­sar­ily mean there are no good stocks or ETFs in the sec­tor. It means the like­li­hood of them is low, so investors should tread carefully.

With only 13 out of 192 energy stocks get­ting an attractive-or-better rat­ing, there are not a lot of good stocks to choose from in the sec­tor. How­ever, given that nearly 40% of the mar­ket value goes to the attractive-or-better-rated stocks, investors and ETFs could make rather large allo­ca­tions to those stocks. On the other hand, the fig­ure above shows that there are 179 energy stocks with a neutral-or-worse rat­ing. These stocks make up about 63% of the mar­ket value of the sector.

Fig­ure 2: Hold­ings Count of Energy Sec­tor ETFs

* # of hold­ings excludes cash

Source: New Con­structs, LLC

Fig­ure 2 shows clearly that energy sec­tor ETFs are not all made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently. Con­se­quently, it is impor­tant to derive a pre­dic­tive rat­ing for ETFs based on analy­sis of the under­ly­ing qual­ity of earn­ings and val­u­a­tion of the hold­ings in each ETF.

Fig­ure 3 shows how the 17 energy sec­tor ETFs stack up ver­sus each other, the over­all sec­tor and the S&P 500 based on their risk/reward rat­ings and the allo­ca­tions to their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

* % may not add up to 100% due to the exclu­sion of cash and hold­ings not in our cov­er­age universe.

Sources: New Con­structs, LLC and com­pany filings

Attrac­tive ETFs:

We find no attractive-or-better-rated energy ETFs.

Neu­tral ETFs:

[[QCLN]] allo­cates its value in a way that earns it a neu­tral rat­ing. We rec­om­mend investors buy the 13 very attrac­tive and attrac­tive stocks in this sec­tor before buy­ing any of the U.S. Equity Energy ETFs except those we recommend.

Dan­ger­ous ETFs:

We rec­om­mend investors sell DIG, [[IYE]], [[VDE]], ERX, [[PXI]], FEG, [[XLE]], [[PSCE]], PXE, [[FXN]], PXJ, [[IEZ]], [[RYE]], XES, [[XOP]], and IEO because of their dan­ger­ous ratings.

Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (192 com­pa­nies) based on data as of July 12 . We aggre­gate results for the ETFs in the same way the ETFs are designed.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s fea­tured our uniquely pre­dic­tive ETF research in “The Dan­ger Within.”

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.