The Energy sector ranks eighth out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 19 ETFs and 87 mutual funds in the Energy sector as of April 3, 2014. Prior reports on the best & worst ETFs and mutual funds in every sector are here.

Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 162), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Energy sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Energy ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Get my ratings on all ETFs and mutual funds in this sector on my mutual fund and ETF screener. Click here for access to more research.

Figure 1: ETFs with the Best & Worst Ratings – Top 5

 Screen shot 2014-04-10 at 9.29.13 AM* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Fidelity MSCI Energy Index (FENY) is excluded from Figure 1 because its total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

Screen shot 2014-04-10 at 9.28.36 AM* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

Vanguard Energy ETF (VDE) is my top-rated Energy ETF and ICON Funds: ICON Energy Fund (ICENX) is my top-rated Energy mutual fund. VDE earns my Dangerous rating while ICENX earns my Neutral rating.

iShares U.S. Oil & Gas Exploration and Production ETF (IEO) is my worst-rated Energy ETF and Saratoga Advantage Trust: Energy and Basic Materials Portfolio (SBMBX) is my worst-rated Energy mutual fund. Both earn my Very Dangerous rating.

Figure 3 shows that 16 out of the 336 stocks (over 10% of the market value) in Energy ETFs and mutual funds get an Attractive-or-better rating. However, zero out of 19 Energy ETFs and zero out of 87 Energy mutual funds get an Attractive-or-better rating.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Energy ETFs hold poor quality stocks.

Figure 3: Energy Sector Landscape For ETFs, Mutual Funds & Stocks

Screen shot 2014-04-10 at 9.27.51 AMSources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors need to tread carefully when considering Energy ETFs and mutual funds, as no ETFs and no mutual funds in the Energy sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors would be better suited to focus on individual stocks in this sector.

Chevron (CVX) is one of my favorite stocks held by Energy ETFs and mutual funds and earns my Attractive rating. Chevron has grown profits (NOPAT) by over 16% compounded annually since 2002 and has a return in invested capital (ROIC) of 9%, which is better than rival ConocoPhillips (COP) at 6% and on par with industry leader Exxon Mobil (XOM). Chevron also has a strong track record in generating economic earnings, earning positive results for nine out of the past ten years. Despite these strong fundamentals and history of profit growth, CVX is still trading at just ~$119/share. This price gives CVX a price to economic book value of 1.0, which implies that the market expects the company to never grow its profits from the current level. In looking at CVX’s competitive position and excellent NOPAT growth over the past decade, these expectations seem too low. CVX offers investors great risk/reward.

Baker Hughes (BHI) is one of my least favorite stocks held by Energy ETFs and mutual funds and earns my Dangerous rating. BHI has seen profits (NOPAT) decline by 1% compounded annually since 2006 with NOPAT now in its second-straight year of decline. BHI also has a return on invested capital (ROIC) of just 4%, which puts it in the bottom quintile of all 3000 companies I cover. BHI has earned increasingly negative economic earnings for the past five years. Despite this less-than-stellar performance over the past few years, BHI has continued to trend higher since its dip in 2012, with the stock currently trading at ~$66/share. To justify this price, Baker Hughes would need to grow NOPAT by 22% compounded annually for the next 13 years. These are lofty expectations for any company, let alone one that has seen its profits stagnate for the past 7 years. Investors should avoid BHI as long as its valuation is this high.

190 stocks of the 3000+ I cover are classified as Energy stocks. Figures 4 and 5 show the rating landscape of all Energy ETFs and mutual funds. My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.

Figure 4: Separating the Best ETFs From the Worst ETFs
EF4
Sources: New Constructs, LLC and company filings
Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds
EF5Sources: New Constructs, LLC and company filings

Review my full list of ratings and rankings along with reports on all 19 ETFs and 87 mutual funds in the Energy sector.

Kyle Guske II and André Rouillard contributed to this report.

Disclosure: David Trainer, Kyle Guske II, and André Rouillard receive no compensation to write about any specific stock, sector or theme.

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