Categorized | Energy ETF

Energy ETF – Understanding ETF Risks

While ETFs totally eliminate company specific risk it is very important to remember that you still face potential investment risks particularly when you invest directly or indirectly in a commodity through an ETF. Keep in mind that your investment could lose money and this risk applies to all exchange traded funds.

Let’s start with passive vs. active management. Is your ETF actively managed or passively managed? In declining markets, the advisor behind an actively managed fund will react by taking defensive positions (such as raising cash) while a passively managed fund will simply suffer greater losses relative to an actively managed ETF. This is very important to consider when investing in the energy sector as we have witnessed the volatility in price movements for oil and natural gas.

A diversified portfolio is always recommended in order to avoid sector concentration. If you are buying an Oil ETF as part of a diversified portfolio this is a risk you should not worry about unless your energy weighting is very high. When you buy an Energy ETF your investments will be concentrated in the energy sector. This means that price volatility experienced by the underlying commodity such as oil or natural gas will be mirrored directly by your Energy ETF and by the oil and gas company stocks which will adversely affect the oil and gas stock ETF performance. Expect the fund value to fluctuate as the energy sector is subject to global economic forces when it comes to oil and gas (market conditions impacting supply and demand). Government policies and regulations might suddenly hit your fund if its investments are geographically limited to one region. For example if the US was to ban hydraulic fracturing many US oil and gas stocks would take a serious hit in price which would be mirrored by several Oil Stock ETFs.

Oil and Gas ETFs are mainly designed to track the performance of an underlying index. It is important to remember that your ETF might fail to match or correlate to that index. This would be mainly the result of fund expenses, a high turnover rate or changes to the composition of the underlying index.  In the case of Oil ETFs and Natural Gas ETFs contango might come into play as the funds hold futures contracts on the commodity and not the physical commodity itself. Contango describes a condition where contracts for a future delivery of a commodity are more expensive that near-term contracts for the same stuff. In order to avoid taking delivery of millions of dollars in physical oil, futures contracts have to be rolled over before they expire which explains why the contract is sold and replaced with a more expensive new one losing money in the process. All of this to say your fund’s performance might be less than what you expect.

Finally, your ETF will mirror market fluctuations as all the stocks tracked within it are subject to the same risks as traditional stocks. For ETFs holding international equities, remember that there’s always a currency risk involved as well as higher political and regulatory risks when it comes to oil and gas companies operating abroad. If you choose to invest in ETFs with holdings concentrated in small and medium-sized companies, remember that these involve greater risks than what is usually associated with investing in large companies. While ETFs make great portfolio building blocks, leveraged ETFs and inverse ETFs are not suitable for all investors. Leveraged ETFs are perfect for quick hit and run trades as they are not designed to track the underlying index over a long period of time. They are only suitable for traders who actively monitor and manage their portfolio.

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