Actively Managing Energy Exposure | ETF Trends

Energy Will Lead to Significant Portfolio Dispersions

The impact of inflation on 2022 portfolio returns led many investors to pile into energy stocks, which contributed a positive 65.84% return on a 2.7% weighting because of the sector’s positive alignments with inflation and earnings growth. According to Bloomberg, this means that it contributed 1.69% in return over a 18.10% loss. Clearly, with no other sector providing a positive return, we can call that alpha! By year end 2022, energy was 5.28%, so while a modest exposure made a meaningful difference for investors in 2022, we believe the sector will have even greater impact in 2023. As a reminder, as of December 31, 2021, according to the S&P Global Indices, an estimated $15.6 trillion was indexed or benchmarked to the S&P 500 index, with about $7.1 trillion in the form of passive funds. All this follows a question from a financial advisor that we received last week.

Energy Exposure

Questions from financial advisors make our days fun at the ETF Think Tank, and this week we were asked: “How can it be that the iShares Growth ETF (IWO) which tracks the Russell 2,000 Growth index has a 6-7% weighting in energy? Isn’t energy a value play?”

Answer: Part One – Differences in Large Cap Integrated Energy Companies

Renewables and alternatives make up the energy category, and yes, Chevron and Exxon are involved in energy alternatives and renewables, despite being mostly known as traditional integrated energy producers. In retrospect this may be obvious, but way too often we think about large companies in simple style box categories. Also, let’s not forget that how a company spends shareholder dollars can amount to future growth prospects, or at least, it is expected to. Barron’s highlighted the complexity of this issue when Brian Swint wrote “BP and Shell vs Exxon and Chevron: the Mystery of Big Oil’s P/E Gap.” Sometimes there is a reason for the cheapness of a stock. As Brian writes, “last year, global oil companies boomed. BP and Shell both based in London, saw share prices rise some 40% in 2022, and trade at five times forward earnings. U.S.-based Exxon Mobil soared nearly 80% and trades at almost 10 times earnings, while Chevron rose 50% and trades at 11 times.”

Swint continues with, “why that gap? Many blame windfall-profit taxes. All the oil giants feasted on rising oil prices after Russia invaded Ukraine. While prices have fallen, they’re still at levels that produce sizable profits. However, European governments are clawing back some of those gains by taxing oil producers to subsidize high energy costs for consumers.” We would also note that Exxon continues to show progress with its spending (read about that here.)

Answer: Part Two – How is Energy Addressed Across Factors

Chart 1: Vastly Different Outcomes Despite IWO and IWN Using the Russell 1000 Index

Chart 2: ETF Think Tank Provides Fund Volatility and Attribution Analysis for Funds

The iShares Russell 2000 Growth ETF (IWO) and iShares Russell 2000 Value ETF (IWN) both hold between 6 and 7% in energy. While the different performance-driving factors will likely lead to performance differences in 2023, the characterization of breaking down the sector as energy is overly simple. Sectors and the conditions that effect the various business models and company opportunities within an industry make for dissimilar outcomes themselves. Also, even when the index methodology and universe is the same, as is the case with the iShares passive ETFs, the outcome is going to lead to significant differences for investors. This is the point of factor investing, but not everyone agrees with the definition of such factors, which can lead to significant dispersion of returns around the same factors. For example, we highlight two large-cap value ETFs – how can it be that there is so little overlap? This is also the case for Distillate US Fundamental Stability & Value ETF (DSTL) and Pacer US Cash Cows 100 ETF (COWZ). This shows that cash flow is at the core of the methodology.

Chart 3Dispersion of Performance (DSTL vs COWZ)

Chart 4: ETF Think Tank Overlap Analysis DSTL vs COWZ (14%)

Chart 5: DSTL vs COWZ Market Cap Comparison

Chart 6: DSTL vs COWZ Highlights Energy Overweighting By COWZ

Chart 7: ETF ThinK Tank Tool Performance Data DSTL VS Broad Group

Summary

Financial advisors and investors need to have an opinion on energy exposure in their portfolio, whether they are strategic allocators or tactical strategists, and whether the focus is on value, growth, or combination of factor ingredients. While energy is the focus of this report, investors need to look under the hood and identify which themes might drive broad indexes in 2023. We often focus on the disconnect between historical returns and current conditions. While the financial advisor’s question that warranted this blog was simple, it led to the larger question about inflation and recession in 2023. To this point, we think the outperformance of this group should be isolated and tracked in a portfolio on a regular basis rather than buried across multiple funds. The sector, like many, is very complex. Ultimately, these changes are an example of why investors need to have an active process to manage portfolios effectively. Don’t let complacency drive portfolio returns! That environment is in the past!

We hope readers find the Tank Tools helpful. Please keep the questions coming.

Best,

Dan

Dweiskopf@tidalfg.com

Energy Vanguard prospectus https://fund-docs.vanguard.com/viccf-annual-report.pdf

https://www.spglobal.com/spdji/en/commentary/article/us-equities-market-attributes


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