The Energy Trap Too Many Fall Into

The energy industry is red hot right now. With exploration and production activity booming domestically, some experts believe the U.S. could actually become fully independent of foreign sources of oil by 2030.

It's only natural for smart investors to want to get in on the ground floor of the opportunity that energy represents. But if you do the easy thing and grab a mutual fund or ETF that specializes in energy stocks, make sure you don't fall into a trap that many people unwittingly fall prey to.

What you get isn't what you want
Exchange-traded funds and sector mutual funds offer the convenience of one-stop shopping. Seemingly without having to do any research, you can simply grab shares and go, confident that you're getting the sector exposure that you want for your portfolio.

But you have to be careful about what a given fund will actually deliver. Not only do various funds use wildly different methods to pick stocks, they also can end up with huge concentrations in just a few stocks, leaving you without meaningful positions in some of the companies you may be most excited about owning.

Keeping up versus falling behind
The problem with most mainstream energy ETFs and mutual funds is that they emphasize the largest oil companies, practically to the exclusion of every other stock. For instance, in the SPDR Sector Energy ETF, the top five stocks make up almost half of the fund's total assets. Even though the fund owns 43 different stocks, the share that its smallest components make up is tiny.

That doesn't match up with what most forward-thinking energy investors want, yet the pace at which the industry is moving makes it almost impossible for passive index-tracking ETFs to keep up. For instance, SandRidge Energy (NYS: SD) has not only moved quickly to emphasize oil and natural gas liquids production over dry gas, but also has spun off interests in potentially lucrative plays as separately traded trusts. One of those is SandRidge Permian Trust (NYS: PER) , which gives investors specific exposure to 20 years' worth of royalty income from the Oklahoma company's holdings in more than 500 initial wells in the West Texas region, along with nearly 900 additional development wells that expect to be drilled in the future.

Similarly, an energy sector fund may leave out important related plays. As an example, Westport Innovations (NAS: WPRT) is an engine maker and seemingly has no connection to the energy industry. Yet as a developer of natural-gas-fueled engines, it could end up playing a critical role in making natural gas a viable fuel source for mass transportation uses. Similarly, Clean Energy Fuels (NAS: CLNE) has received funding from Chesapeake Energy (NYS: CHK) to create a network of 150 natural gas fueling stations around the country -- outlets that will encourage users to migrate to gas-based vehicles without fear of being left stranded with nowhere to fuel up.

One size doesn't fit all
There's no denying that funds and ETFs give investors a lot of convenience. It's a whole lot easier to buy a single investment than to painstakingly research dozens of different individual companies to figure out which ones you want to buy for your portfolio.

But those funds are only as good as the stocks they happen to own. If you can't find one that really matches up with the exposure you're looking to get, then settling for second best will at best leave you disappointed and at worst could cost you a ton of money, either in lost profit opportunities or in outright losses.

So make sure that before you just grab the first ETF or sector fund you find on the shelf, look to see if it owns the stocks you really want to own. Otherwise, you'll probably get a nasty shock at some point in the future when you find out the hard way that you didn't get what you thought you were buying.

If you like energy stocks, we've got a stock idea that could knock your socks off. Read about it right here in The Motley Fool's special free report on the energy industry and its best prospects -- it's free but only available for a limited time, so click here today.

At the time thisarticle was published Fool contributor Dan Caplinger loves ETFs but recognizes their limitations. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always feels energetic.

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