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Commodity ETFs

Pretty much every investor, regardless of focus, has heavy exposure to major oil companies such as ExxonMobil (XOM - Analyst Report) or Chevron (CVX - Analyst Report). These energy behemoths dominate cap-weighted indexes that many ETFs are based on and they also occupy a large share of assets in mutual funds as well. Luckily for many investors, these companies have done quite well over the years and seem poised to continue to dominate thanks to the slow adoption of alternative fuels and the rapid expansion of emerging markets that need cheap fuel to continue their incredible growth.

While these securities have been world-class investments for quite some time, some are beginning to grow worried that their reign over the market is nearing an end. In addition to concerns over increased regulation, taxes, and clean energy, the firms are beginning to finally experience heavy competition from their counterparts in emerging markets. These companies, often times with the backing of their governments, are able to thoroughly control a particular nation, potentially squeezing out companies that are more investor focused and Western-based (read Top Three High Yield Real Estate ETFs).

This is especially the case for state-owned (or at least partially state-owned) firms such as Petrobras (PBR - Analyst Report), CNOOC (CEO - Analyst Report), and Petronas which ensure that their home countries remain more or less off limits to Western oil interests. In fact, when looking at worldwide reserves allocated to each company, not a single investor-owned firm is in the top 10 and ExxonMobil, Chevron, Total (TOT - Analyst Report), and (BP - Analyst Report), combine to hold just over 2% of total world reserves. Thanks to this reality, investors now have two options; try their luck at partially state-owned firms such as Petrobras, or look to small cap securities instead.

Small caps could potentially be an excellent choice in the oil market for a few reasons. First, few investors have exposure to the space, as these securities are often absent from broader portfolios for all but the most diversified of investors. Furthermore, many small cap oil companies, much like their counterparts in the biotech/pharma space, have high quality assets that could make them potential takeover targets by their large cap peers. This could especially become the case if these large caps grow increasingly desperate to expand their production capabilities and even more so if emerging oil companies continue to leave Western firms on the outside looking in. This could be a trend in the near future as many oil firms have developed incredible cash balances that will need to be deployed at some point. A recent look at these reserves suggests that TOT, XOM, and CVX combine to have more than $50 billion in cash on their books, enough to buy a company the size of Devon Energy twice over (Three Outperforming Active ETFs).

IOIL In Focus

For investors seeking broad sector exposure to this space, IndexIQ’s IQ Global Oil Small Cap ETF could make for an interesting choice. The fund tracks, before fees and expenses, to the price and yield performance of the IQ Global Oil Small Cap Index. The benchmark provides exposure to global small cap companies engaged in the oil sector, including in the areas of exploration and production, refining and marketing, and equipment, services and drilling (also see Three Low Beta Sector ETFs).

IOIL holds about 60 securities in total, with exposure roughly split down the middle between U.S. and international securities. The fund is slightly skewed towards refining and marketing companies although, exploration, and equipment firms also receive sizable chunks as well. In terms of individual securities, the Dutch company Core Laboratories (CLB - Analyst Report) takes the top spot but it is closely trailed by Oceaneering International (OII - Snapshot Report) and HollyFrontier (HFC - Snapshot Report)

While the fund may have an interesting holdings breakdown, there are a few downsides that investors should be aware of. First, like most small cap-focused ETFs, the fund is more expensive than its large cap peers, charging 75 basis points a year in fees. Investors should also note that the product has failed to attract a meaningful number of assets so far and average volume is below 5,000 shares a day while the underlying holdings aren’t the most liquid either. This could result in significant bid/ask spreads which could increase the total cost of investing in the fund (see ETFs vs. Mutual Funds).

Nevertheless, for investors with a longer-term focus, the product could make for an excellent pick. The fundamentals of the oil industry are pretty strong and the small cap space could see a surge in interest if their larger cap counterparts get desperate for more resources and opportunities in the near future. Thanks to this, IOIL, if one can get by the low trading volumes and high fees, could be a quality choice as a satellite holding in a well-diversified portfolio.

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