Energy Sector ETFs Could Incinerate Your Savings

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

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 ten 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 must 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

Sources:   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.

Methodology

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, 2011. 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 receive no com­pen­sa­tion to write about any spe­cific stock, sec­tor or theme.

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