Oil prices have been extraordinarily volatile this year. Crude oil entered this year in the $60s before plummeting along with demand as governments restricted travel and nonessential businesses to slow the spread of COVID-19. At one point, the primary U.S. oil benchmark, West Texas Intermediate, crashed into negative territory. Oil has since staged an epic recovery -- including zooming a jaw-dropping 88% in May -- and was recently back around $40 a barrel.
All that movement is fueling an increase in speculative trades in the oil market. One of the main vehicles these traders are using is oil EFTs. Some of the most popular ones are United States Oil Fund (NYSEMKT:USO), ProShares Ultra Bloomberg Crude Oil ETF (NYSEMKT:UCO), and Direxion Daily S&P Oil & Gas E&P Bull 2X Shares (NYSEMKT:GUSH), which each rank among the 100 largest holdings on stock trading platform Robinhood.
However, those oil ETFs are incredibly risky, compounding the perils of investing in the volatile oil market. Investors should ditch those options and consider purchasing the Vanguard Energy ETF (NYSEMKT:VDE) instead. Here's why.
Breaking down the issues with these popular oil ETFs
The purpose of most oil ETFs is to enable investors to earn returns that roughly correlate with the movements of a specific index, market-subsector, or commodity price. For example, the U.S. Oil Fund aims to match the daily price movements of WTI. Unfortunately, it has done a horrible job, as it has unperformed that oil benchmark by a wide margin (WTI is down about 50% over the last three years while USO has plunged more than 80%). That's due to a combination of its management fees and the method it uses to track WTI, which involves trading in oil futures contracts. As the contracts it owns near expiration, the fund sells them to buy ones that expire farther into the future, which often costs more money.
The other two ETFs throw an additional wrinkle into the mix, as they use leverage to deliver twice the daily price movements of the index they track (WTI for the ProShares ETF and the S&P Oil & Gas Exploration & Production Select Industry Index for the Direxion ETF). While that means speculators could make twice as much if the underlying index moves the way they anticipate, losses will pile up at a faster rate if they're wrong. Given all the volatility in oil prices, this leveraged bet is a risky gamble. That's evident in their returns over the past year. While WTI and the S&P Oil & Gas Index are both down roughly 50% in the last year, these ETFs have each lost more than 85% of their value.
A better way to invest in oil
The oil market is challenging even for the most seasoned investors, making it tough to pick oil stock winners. Because of that, oil ETFs can be a great way for investors to add some oil exposure to their portfolio. While there are lots of good options, one of the best is the Vanguard Energy EFT. That's because it has a simple strategy of aiming to track the performance of the energy sector without the added complexity and risks associated with leverage or oil futures contracts.
The ETF currently holds shares of more than 130 oil stocks, giving investors broad exposure to the entire sector, though it's heavily weighted toward the top ten. That group encompasses 72% of its current assets. It includes leading oil producers like ExxonMobil and Chevron, refining giants like Phillips 66 and Valero, and top pipeline operators such as Kinder Morgan and Williams Companies. That combination of diversification and weighting toward the top players helps reduce risk.
Meanwhile, Vanguard Energy ETF charges a low expense fee of 0.1%, which cuts down the drag on returns. For comparison's sake, USO charges a 0.45% expense fee, UCO's is 0.95%, and GUSH's is 1.05%.
While the Vanguard Energy ETF has struggled along with most other oil stocks over the past year, it has performed better than these rival EFTs as it has only declined by about 40%. It should be able to continue outperforming them in an oil market recovery, especially if there's lots of volatility on the way up, which would likely cut into their returns.
Ample upside with less risk
EFTs can be an excellent way to make a directional bet on a stock market sector like energy if an investor chooses the right one. In the case of the oil market, one of the standout options is the Vanguard Energy ETF. Instead of trading oil futures and using leverage, it provides diversified exposure across the top-tier oil stocks. Its price should gain as the market recovers, with less risk of implosion if it's a bumpy ride.