Energy ETFs explained
An Exchange Traded Fund (ETF) is a security that tracks an index, commodity or basket of assets within an index or category. ETFs were first introduced in the early 1990s as a lower cost alternative to professionally managed mutual funds.
ETFs behave like common stocks. They can be bought and sold on an exchange and prices are allowed to fluctuate throughout the day. Expense ratios are traditionally low, normally in the range of 0.1 to 1%. This makes ETFs far less expensive to own than traditional mutual funds which normally charge 2-5% of fund holdings.
ETFs offer the simplicity of a common stock with all the benefits of index funds. Advantages of using ETFs are as follows:
- ETFs have much lower expense ratio than mutual funds, making them less prohibitive to buy or sell. Unlike mutual funds, there is typically no minimum investment required and no redemption fees.
- ETFs trade throughout the day, making them easy to buy and sell. Unlike mutual funds, there are no lock-up periods and no restrictions on withdrawal amounts.
- ETFs can offer excellent diversification, particularly for smaller portfolios. For example, instead of investing in one energy company, an energy ETF will provide exposure to a basket of energy stocks. This also removes the risk of an unforeseen event with any one particular stock (such as an earnings miss or unplanned production outage).
There are literally thousands of ETFs on the market. Selecting the right ETF can be a daunting task. Here are a few of the most popular types of energy ETFs in Canada and the US.
Index ETFs are securities that simply reflect the weightings of an underlying index or stock exchange (such as the TSX Composite, Dow Jones Industrials, or the Nasdaq Composite). The most common Canadian index ETF is XIC (iShares S&P/TSX Capped Composite Index ETF). Since energy stocks make-up 25% of the TSX, XIC has a corresponding 25% weighting in Canadian energy companies. XIC therefore offers great exposure to Canada’s oil and gas sector while still being relatively well diversified within different sectors. XIC also offers an impressive 2.7% yield (or dividend).
Another option for investing in the energy market is to purchase a commodity ETF which represents the price of the underlying commodity. The most popular crude oil ETF is the United States Oil Fund (USO), which represents the near term futures contract of West Texas Intermediate (WTI) crude. For a broader basket of oil and gas commodities, DBE (Powershares DB Energy Fund) offers a mix of WTI, Brent crude, heating oil, natural gas and gasoline. Both USO and DBE are denominated in US dollars. For Canadian investors, US denominated ETFs provide a hedge against a falling Canadian dollar.
"Substituting an individual stock with an ETF is a great way to invest in a sector or asset class without all the risks of owning a specific security."
Stock or Sector ETFs
Stock ETFs represent a basket of stocks that share common traits (such as company size, sector or geographic location). The broadest energy ETF in Canada is XEG (iShares S&P/TSX Capped Energy Index), which is composed mostly of oil and gas producers and a few oil field service companies. The 3 largest holdings in XEG are Suncor, Canadian Natural Resources and Cenovus which account for 40% of the ETF. Oil sands producers are therefore very well represented within XEG. XEG also yields an excellent dividend of 2.0%.
For a more concentrated weighting in the oil sands, iShares also offers CLO (iShares Oil Sands Index Funds), which is comprised of 13 different oil sands producers. The top 3 holdings in CLO are Suncor, Canadian Natural Resources and Imperial Oil, which together make up 35% of the ETF.
Denominated in US dollars, FRAK (by Van Eck Global) offers participants a chance to invest in the North American unconventional oil & gas producers, which includes coal bed methane, shale oil as well as the Canadian oil sands. FRAK is weighted 26% in Canada and includes major oil sands producers such as Devon, Cenovus, Husky, Talisman and MEG Energy. Since FRAK is denominated in US dollars, Canadian investors would benefit from a falling Canadian dollar.
For investors searching yield, Horizons recently announced a Canadian midstream oil and gas exchange traded fund, HOG. The Canadian oil and gas midstream sector includes companies involved the transportation, storage, and marketing of crude oil, natural gas and other refined petroleum products. This ETF includes popular pipeline stocks such Enbridge, TransCanada, Pembina and Inter Pipeline. HOG offers an attractive dividend, currently about 4% and offers good diversification within the energy sector. Infrastructure and pipeline stocks are less volatile than energy producers and generally do not follow the price of underlying commodity (such as crude oil or natural gas). Instead, midstream stocks are more interest rate sensitive and have performed very well under the current low rate environment. HOG trades on the TSX and is denominated in Canadian dollars.