Zacks Equity Research — ZACKS — Mon Dec 01, 7:00AM CST

Article Comments (0)

The energy sector was performing quite well for the most part of the year due to supply disruptions caused by relentless geopolitical tensions across the globe. However, the space has now given up almost all of its previous gains thanks to sluggish demand, booming oil production, abundant supply and a strengthening dollar.

Oil prices which were trading in the triple-digit mark in the first half of the year, are now trading below $80 per barrel – a five-year low on the back of a strong greenback and weak demand outlook for oil. Recession in Japan, slowing growth in China and recessionary fears in Europe seem to be the culprits for the weak outlook (read: ETFs to Watch on Japan Recession Shocker and Snap Election ).

In this backdrop, energy ETFs have seen some terrible trading in the past few months losing in the double digits. In fact, the most popular ETF in the space – Energy Select Sector SPDR (XLE ) – is trading in the red in the year-to-date frame.

In spite of the weak trading so far, things are not expected to improve in the near term given the weak demand outlook for oil. As such, investors willing to remain invested in the energy space should choose cautiously as to which product to invest in (read: 2 Sector ETFs to Benefit from the Crude Oil Slump ).

Undoubtedly XLE which uses a cap weighted strategy is a good option to play the space, but a product like S&P Equal Weight Energy ETF (RYE ), which is a broad play on the energy sector, might provide investors with more diversification benefits in the longer run.

XLE manages a huge asset base of $9.8 billion and has seen inflows worth $2.95 billion in the year-to-date frame. The fund is also pretty liquid with average trading volume of roughly 20.5 million shares. RYE on the other hand is less popular with an asset base of $98.7 million and trading in low volumes of roughly 50,000 shares a day. Investors have poured roughly $72.69 million in RYE in the year-to-date frame.

The huge inflows seen in XLE suggest that investors have definitely favored XLE over RYE. Part of the reason for the popularity might be due to the fact that XLE has been around quite a bit longer having been launched in 1998 and is also quite cheaper than RYE, which was launched in 2006.

RYE charges 40 basis points as compared to 16 basis points charged by XLE. Both the funds, however, provide exposure to the same industries within the energy sector, namely oil, gas & consumable fuels and energy equipment & services.

Moreover, the fact that assets chase more assets in the ETF world also explains XLE’s popularity in terms of AUM accumulation. Investors usually favor more popular funds for higher levels of tradability and better bid ask spreads; so XLE has definitely been a beneficiary of this trend.

Cap Weighted Vs Equal Weighted

However, the main difference between the two funds is the underlying index. XLE tracks the Energy Select Sector Index which uses a market cap weighted methodology, focusing on the large cap segment of the energy sector (read: Overweight These Equal Weight ETFs in Your Portfolio ).

RYE, on the other hand, tracks S&P Equal Weight Index Energy, which follows an equal weighted strategy. This approach gives equal allocation to the entire spectrum of securities in similar amounts and as such minimizes concentration risk.  Moreover, the fund uses quarterly rebalancing and as such tends to book profits in on the overvalued stocks and reinvests in the underperforming ones.

Due to the equal weighted strategy, RYE reduces overall risk as the performance of the fund is not dependent on the returns of a particular stock or group of securities. This is especially true as none of the individual holdings of RYE has more than a 3.5% exposure level in the fund. In fact, the top three holdings – Tesoro Corporation, Kinder Morgan Inc and Marathon Petroleum Corp – together have just a 6% combined exposure in the fund.

XLE, however, is heavily dependent on the performance of its top three holdings – Exxon, Chevron and Schlumberger NV – as they occupy a combined 37% of fund assets.

Also, XLE primarily focuses on large caps with a very small exposure (15%) to mid caps. However, RYE provides a nice balance between large and mid caps with roughly equal exposure (read: Buy These 3 Top-Ranked Mid Cap ETFs to End 2014 ).

XLE has however outperformed RYE in the trailing one-year and three-year period by a good margin. However, both funds have returned roughly the same in the trailing five years.