Investing in energy ETFs? Choose what best fits your outlook

Passive index exposure is only one alternative.

Yves Rebetez 19 April, 2016 | 5:00PM
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If you've heard it once, then you might have heard it hundreds of times: Canada's broad equity benchmark is insufficiently diversified. Besides financial services, it's heavily weighted in energy and materials. During boom times for commodities, this is great. But in recent memory, not so much.

This raises the question: Why would anyone want to invest in an exchange-traded fund specializing in the oil and gas sector? The answer: For some of the same reasons you'd pick a broad Canadian equity ETF. The attractions include diversification by security, low cost and, in the case of index ETFs, the presumption that actively managed energy funds will generally fail to beat the sector's benchmark.

When oil or natural gas prices plummet -- as they have over the past 18 months -- stock prices will tend to move in the same direction. Even so, diversification by security within the same sector is beneficial.

For example, one energy producer may have made timely acquisitions while another may have over leveraged itself at the top of the market. Furthermore, the business models of energy companies will differ. Some are pure exploration and production plays, while others are integrated companies that own refineries or distribution assets such as gas stations.

So far in 2016, oil prices have rebounded, defying bearish pundits who had predicted that oil at US$20 per barrel was a foregone conclusion. After having plunged to below US$30, it has surged back toward US$40, despite inventory overhang and oversupply concerns including Iran's return to the market.

Given the recent strong rebound in energy stocks and in the price of crude oil, you may wish to reassess your energy exposure. Through ETFs, there are now more ways than in the past in order to find a better match with your outlook for the sector.

The largest and most widely held energy ETF is the $1-billion iShares S&P/TSX Capped Energy Index (XEG), a logical choice for investors who want broad exposure to the sector that's based on market capitalization.

Employing a different but still passive strategy is BMO S&P/TSX Equal Weight Oil & Gas Index (ZEO). In a bull market for the sector, you could expect BMO's ETF to achieve higher returns than its market-cap-weighted rivals. The reason: the index's small- and mid-cap constituents may outperform, either on their own merits or as a result of merger and acquisition activity.

In bearish markets, the opposite could be true. Larger-capitalization companies may either be more conservatively positioned, or be believed by investors to have better odds of surviving another plunge in commodity prices.

Another alternative among ETFs with energy-company exposure is the swap-based Horizons S&P/TSX Capped Energy Index (HXE), which holds futures contracts and cash instead of holding the index stocks directly. Along with eliminating tracking error versus its benchmark index, HXE will appeal to investors in non-registered accounts. Since the ETF does not make distributions, income tax can effectively be deferred.

While HXE's detractors will point to the issue of counter-party risk, this risk is limited by collateral requirements to 10% of the net asset value of the ETF. Regulators also require the counter-party to be AA rated, so default risk is minimal.

Interestingly, the counterparty risk can be negative, such as when the aggregate cash position held as collateral for the swap is of greater value than the current value of the underlying market exposure the counterpart is obligated to remit. This, incidentally, is currently the case with HXE.

In the strategic-beta camp, seeking to outperform the market benchmark with a rules-based strategy, is First Trust AlphaDEX U.S. Energy Sector Index (FHE). Investors in this ETF would be those attracted to its strategy of screening for superior financial ratios, while also aiming to identify and remove the worst 25% of stocks in the index from which its constituents -- 61 of them currently -- are drawn. With assets of less than $2 million, FHE highlights the challenge of getting Canadians to look beyond ETFs that provide domestic energy exposure.

Investors who are ambivalent about the outlook for the energy sector, but are still looking for some exposure, can invest in ETFs that employ covered-call strategies. The choices here include First Asset Energy Giants Covered Call (CAD Hedged) (NXF), which writes covered calls on up to 25% of the portfolio, and Horizons Enhanced Income Energy (HEE), which makes more extensive use of covered calls.

By writing call options several times in a row -- or so the strategy goes -- the ETFs can potentially achieve greater risk-adjusted returns. Bear in mind, though, that covered-call energy ETFs will typically have higher costs than their passively managed counterparts.

Along with being taxed favourably as capital gains, the premiums earned by covered-call writing serve as the first line of defence against falling stock prices. In a volatile sector like energy, the option premiums are juicer, and thus could provide some additional upside.

If you are strongly bullish about the energy sector, you should avoid covered-call ETFs since you'll want to avoid capping any upside. As well, if you are outright bearish, ask yourself: Will the option premiums more than offset falling stock prices? If not, selling or reducing your exposure would be the preferable course of action.

If you fancy yourself more of a trader, and are looking to place bets on the price direction of oil or natural gas, there are ETFs that are pure plays on commodity prices. They include Horizons NYMEX Crude Oil (HUC), Horizons NYMEX Natural Gas (HUN) and Auspice Capital Advisors Ltd.'s Canadian Crude Oil Index (CCX).

When comparing energy-company ETFs to those that invest in energy commodities, the most important point for investors to understand is that energy commodities are much more volatile than energy stocks.

This is especially so for the Horizons ETFs that employ leverage or inverse leverage. They can produce spectacular results when you are on the right side of the trade and the market environment works in your favour. Conversely, investing in them may prove extremely painful in other scenarios. For that reason, the Bull+ and Bear+ commodity ETFs offered by Horizons are to be avoided by all but the most knowledgeable and risk-tolerant traders.

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About Author

Yves Rebetez

Yves Rebetez  Yves Rebetez, CFA, is managing director of ETF Insight. He specializes in research and analysis of ETFs and closed-end funds. Before launching his independent firm, he was vice-president of ETFs and structured products with RBC Dominion Securities. He also worked as a portfolio advisor or portfolio manager at RBC Dominion Securities, Credit Suisse Canada and UBS in Switzerland.

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