Energy ETFs: Can They Continue to Outperform?

Energy ETFs have outperformed for almost a decade. According to most measurements, energy is now the third largest industrial sector by market capitalization (after technology and healthcare). But factors which made investment in energy ETFs successful are changing. How will these affect energy sector ETFs?

There are four classic broad US-based energy ETFs: the Energy Select Sector SPDR Fund (NYSEArca: XLE), the Vanguard Energy ETF (NYSEArca:VDE), iShares Dow Jones U.S. Energy Sector Index Fund (AMEX:IYE), and the iShares Goldman Sachs Natural Resources Index Fund (NYSEArca:IGE). The chart below compares the performance of these funds with the benchmark Standard and Poor's Depository Receipts (AMEX:SPY):

The chart shows that the performance of XLE, VDE and IYE are almost identical. IGE lags. Part of the reason for the similar performance of these ETFs is that the energy sector is heavily concentrated in just a few names. Five companies (Exxon Mobile, Chevron Texaco, Royal Dutch Shell, B.P. Amaco, and Total SA) represent two thirds of the market capitalization of the energy sector. XLE, VDE and IYE allocate accordingly. Exxon and Chevron together represent about 40% of the value of these funds. IGE is more diversified but consequently less representative of the sector as a whole. IGE also has a higher expense ratio. Given the similar performance of these funds, for energy investors we favor the low cost leaders and those with the longest track record: XLE and VDE.

But before diving in, investors should reflect that while strong global growth and rising natural resource prices have made energy ETFs the markets' darling, the world-wide expansion that fueled their rise has become a contraction. This changes the overall outlook for the sector and suggests that short-term there may be better opportunities elsewhere. Slowing growth means less demand for energy and cheaper raw materials prices. This hurts companies with oil assets. But oil prices will likely accompany any improvement in the economy. Also, in periods of weaker oil prices, diversified oil companies will see increased profits from refining operations and petrochemicals. The majors all have refining operations, and this will help their bottom line.

The energy sector is also tied to the larger credit cycle, and particularly the dollar. In the last few years the trend to a weaker dollar created an increase in dollar borrowing and inflation, which helped the boom in raw materials prices. Even when demand returns, deleveraging and lower inflation may keep materials prices weak. On the flip side, central banks around the world are dropping their interest rates to historically low levels and governments are spending assertively on stimulus packages. Economists expect inflation to return in the not too distant future. In times of reflation, oil has typically climbed. It presents an attractive hedge to inflation. Investors in energy ETFs should consider this cycle.

Past growth in the energy sector has been accompanied by a boom in ETF issuance. Up from just a handful of broad market ETFs a few yerars ago the sector is represented today by an impressive, even bewildering, array of ETFs. There are a number of specialized energy ETFs, including energy sub-sector ETFs, energy strategy ETFs, and alternative energy ETFs. There are also ETFs that hold primarily commodities futures contracts and seek to track the price of oil and other refined products, finally there are leverage and specialized trading product. The most important of these ETFs are listed below:

Sub-Sector

SPDR S&P Oil & Gas Exploration & Production ETF (NYSEArca:XOP)

SPDR S&P Oil & Gas Equipment & Services ETF (NYSEArca:XES)

iShares Dow Jones U.S. Oil Equipment & Services Index Fund (NYSEArca:IEZ)

iShares Dow Jones U.S. Oil & Gas Exploration & Production Index Fund (NYSEArca:IEO)

First Trust ISE-Revere Natural Gas (NYSEArca:FCG)

Market Vectors Nuclear Energy ETF (NYSEArca:NLR)

Market Vectors Coal ETF (NYSEArca:KOL)

Alternative Energy

PowerShares WilderHill Clean Energy Portfolio (NYSEArca:PBW)

First Trust Global Wind Energy (NYSEArca:FAN)

Claymore Global Solar Energy ETF (TAN)

Van Eck Global Alternative Energy ETF (NYSEArca:GEX)

PowerShares Global Clean Energy Portfolio (NYSEArca:PBD)

PowerShares Cleantech Portfolio (NYSEArca:PZD)

PowerShares WilderHill Progressive Energy Portfolio (NYSEArca:PUW)

First Trust NASDAQ Clean Edge U.S. Liquid (NasdaqNM:QCLN)

Raw Materials

United States Oil (NYSEArca:USO)

United States Gas (NYSEArca:UGA)

United States Heating Oil Fund (NYSEArca:UHN)

United States Natural Gas Fund (NYSEArca:UNG)

Global/Foreign

iShares S&P Global Energy (NYSEArca:IXC)

WisdomTree International Energy Sector Fund (NYSEArca:DKA)

Claymore/SWM Canadian Energy Income (NYSEArca:ENY)

Strategy

Powershares Dynamic Oil & Gas Services Portfolio ETF (NYSEArca:PXJ)

Powershares Dynamic Energy Exploration & Production Portfolio ETF (NYSEArca:PXE)

Powershares Dynamic Energy Sector Portfolio ETF (NYSEArca:PXI)

Powershares FTSE RAFI Energy Sector Portfolio ETF (Nasdaq:PRFE)

Trading/Leverage

ProShares Short Oil & Gas ETF (NYSEArca:DDG)

Ultra Oil & Gas ETF (NYSEArca:DIG)

UltraShort Oil & Gas ETF (NYSEArca:DUG)

Energy Bear 3X - Triple-Leveraged ETF (NYSEArca:ERY)

Energy Bull 3X - Triple-Leveraged ETF (NYSEArca:ERX)