Exchange-traded funds have become quite a popular vehicle for investors wanting to play an entire sector at once. This makes sense as these usually passive vehicles trade throughout the day at prices that are almost always perfectly aligned with net asset value and have extremely lost costs. However, it can be challenging for investors to decide which one to buy to play a thesis as nearly every asset manager offers funds using the structure and each of these oftentimes have both things in common and things that differ. In this case, we will take a look at two funds that can be used to play a thesis in the energy industry. For most investors looking to place a broad bet over the long term, I think that the best option is the Fidelity MSCI Energy Index ETF (FENY).
About The ETF
As is the case with most exchange-traded funds, FENY is a passively-managed fund that is designed to track the performance of an index. In this case, that index is the MSCI USA IMI Energy Index, which ostensibly represents the performance of the energy sector in the U.S. equity market. This differs from the index tracked by the more popular iShares U.S. Energy ETF (IYE), which follows the Dow Jones U.S. Oil and Gas Index. As might be expected though, both indices are quite similar.
The usual practice for passive ETFs that track an index is to simply purchase all of the securities in the index with respective weightings. This is the strategy used by FENY, which consists of 134 different stocks, although the ten largest holdings comprise 66.74% of the fund's assets.
Source: Fidelity Investments
These companies are the ten largest energy companies in the United States. As might be expected then, these same companies are the top ten holdings of IYE, although the weightings are slightly different:
The first thing that we notice is that despite having a portfolio of 134 different assets, the fund's portfolio is extremely concentrated. As a general rule, I dislike seeing any asset accounting for greater than a 5% weighting in the fund. This is because this is about the level where the asset begins to expose the fund as a whole to idiosyncratic, or company-specific, risk. In short, if some event occurs that causes the stock price of a heavily-weighted company to decline independently of the rest of the portfolio, then it will drag the rest of the fund down with it. As we can see, there are three stocks in FENY that have greater than a 5% weighting with two of them, Exxon Mobil (XOM) and Chevron (CVX), accounting for a massive 38.42% between them.
The performance of the two ETFs has also been essentially identical over the past five years, despite the slight differences in the underlying indices.
Source: Fidelity Investments
Please note that we only go back five years here due to the fact that FENY has only existed since October 21, 2013 so there is no data available for it prior to that date. While we could backtest the underlying index, I believe that doing so is rather pointless as we can clearly see that the two ETFs perform almost identically, with the slight differences between them explainable by factors that will be discussed later in this article.
Why Invest In Energy?
The energy sector has been an interesting one over the past decade due largely to the technological innovations that have made techniques such as horizontal drilling and hydraulic fracturing arguably economically viable. These developments have allowed the United States to significantly grow its oil production, diluting the power of Saudi Arabia on the world stage and ultimately allowing the United States to become a net exporter of oil. At the same time, we have seen two times when the price of oil collapsed, which naturally has a significant negative impact on the stock prices of energy companies. This has resulted in the energy sector being the singularly worst performing one in the S&P 500 over the period.
The United States Energy Information Administration projects that oil produced in the United States' shale plays, ultra-deepwater, and other unconventional regions of the world will account for a greater proportion of the world's energy mix going forward. We can deduce this by looking at the fact that the agency expects crude oil production to increase modestly over the next few years and then flatten out:
Source: U.S. Energy Information Administration
The reason that we can conclude that unconventional production must increase is that many of the older conventional fields that have been responsible for much of the economic prosperity in areas such as the Middle East have entered a period of terminal decline. Therefore, if production is to remain flat or increase, unconventional sources must increase their outputs in order to make up for the declines elsewhere. As it costs considerably more to produce oil using unconventional methods as it does in conventional fields, oil prices must necessarily rise over today's levels going forward if this growth is to occur on any sort of sustainable basis.
As we can see in the chart above, the production and consumption of natural gas is expected to grow more than the same metrics for any other fuel source between now and 2050. This is the result of governments around the world attempting to reduce their emissions of greenhouse gases as natural gas burns cleaner than any other fossil fuel. The United States is home to some of the largest deposits of natural gas in the world as evidenced by the enormous reserves in areas such as the Marcellus shale, DJ basin, Utica shale, and others. These reserves should allow the United States to become a major exporter of natural gas over the coming years. In fact, we are already beginning to see this play out with the numerous LNG projects that are underway throughout the country. The reason why this will be good for the nation's energy companies is that many of them produce natural gas in addition to oil. EOG Resources (EOG), for example, owns large tracts of acreage in several natural gas shale regions and Exxon Mobil is the largest producer of natural gas in the nation. As these companies are forced to grow their production in order to meet demand, they should be able to benefit from growing revenues and cash flows.
Which ETF Is Better?
In the introduction, I suggested that FENY is likely a better fund for long-term investors than IYE. One of the biggest reasons for this can be found in its expense ratio. As the name implies, the expense ratio is the fee that the sponsor charges the fund to cover the costs of management, marketing, and other services provided to the fund. The expense ratio also reduces the fund's returns by the amount of the fee. Therefore, the lower the fund's expense ratio, the more of the returns that shareholders get to keep and even slight differences can add up over time. Therefore, investors that intend to hold a fund for any length of time should favor funds with the largest expense ratios so that the greatest amount of their returns end up in the investors' own pockets. As with all of the Fidelity ETFs, FENY has an expense ratio of just 0.084%. The iShares ETF, however, is much higher at 0.43%. This 34.4 basis point difference could certainly add up to a significant amount of money over an extended time period. This expense ratio difference could also be a reason why FENY has a higher trailing distribution yield, 3.05% compared to 3.00%.
On the flip side, IYE is a larger fund than FENY and has much greater liquidity. This could make the iShares fund a better option for short-term dayrates and others that want to move in and out quickly. This advantage is likely to be slight, though, as it is exceptionally rare for ETFs to trade at a value that is out of line with net asset value so both funds should move very similarly to each other as the underlying investments are so similar. Thus, the improved liquidity is likely a very minor consideration.
In conclusion, every investor should maintain some exposure to the energy industry, despite the markedly poor performance that it has delivered over the past decade. The future of the industry, particularly in the United States, looks to be quite bright. While there are many ways by which investors can play the industry, perhaps the best broad-based sector ETF is the Fidelity MSCI Energy Index ETF as its extremely low costs result in a greater proportion of the fund's total returns remaining with investors, which should add up to a lot of extra money versus comparable funds over time. Overall, this looks like a good way to play this growing sector.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.