Energy ETFs: Big Profits, Lower Risk

05/30/2011 7:00 am EST

Focus: ETFS

Two big fundamental shifts are unfolding in the energy sector, and investors can use ETFs to specifically target the best growth areas without the risk that comes with choosing individual stocks.

Energy is a topic that dominates the news. We’re constantly hearing about rising prices at the gasoline pumps, the ongoing global war for oil, and the push for cleaner, greener technologies.

Thanks to the soaring demand for new energy sources—fueled by growth in emerging markets—we’re entering an historic era for energy investments.

Now with all of that said, let me ask you a simple question:

Without visiting wind farms or getting a degree in geology, how is it possible for an individual investor to make money from this extraordinary trend? After all, if you’re like me, I’m sure you know plenty of people who have lost money by “gambling” on individual energy stocks.

Several years ago, I worked with someone—an incredibly bright guy, Paul K.—who lost thousands of dollars on speculative energy investments back in the early ’90’s.

It wasn’t so much that Paul was a bad investor; he just kept chasing the next big oil discovery.

It used to be that making big money in energy was a bit like playing the lottery. You’d hear about an exploration company that had a good story and you’d plunk down your hard-earned cash and hope they struck oil.

Every once in a while—at a cocktail party, most likely—you might hear a story from someone who made a killing from an oil strike. Of course, it was much more common to hear stories about investments that lost money.

But those days are over.

Thanks to a relatively new investment vehicle, you can harness the power of energy investing and make “speculator-sized profits” without visiting a single drilling site. Let me show you what I mean.

Thanks to the combination of two fundamental shifts, it’s possible for individual investors to take enormous stakes in very targeted, specific energy investments while at the same time limiting their risk.

The first of these fundamental shifts is in the global demand for energy. Thanks to the explosion in energy demand from countries like Brazil, Russia, India, and China, our global energy resources are being quickly depleted.

Add to it concern over the geopolitical dangers associated with Middle Eastern oil and the push for clean energy technologies and the energy landscape has changed in a huge way.

Couple this explosion in energy demand with the second fundamental shift—the change in how investors can profit from specific “pockets” of the market—and you have a true game-changer.

Not that long ago, institutional investors had a clear advantage over the little guy when it came to making money in the markets. That’s because when their research showed that a particular sector was about to pop, they could simply gobble up every stock in that sector.

Individuals like you and me didn’t have the resources to do something like that. So we were left to grab a handful of companies and hope for the best.

But that’s all changed thanks to the invention of the ultimate investor’s “power tool”: exchange traded funds (ETFs).

NEXT: Using ETFs to Play the Energy Sector

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You might think of an ETF as simply a way to invest in a particular index, like the Nasdaq or the S&P 500, but the explosion in growth of ETFs over the last five years has created a world of new opportunities, even though only a small number of individual investors have figured out how to take full advantage.

What’s more, ETFs are the perfect vehicle to help individual investors capitalize on the fundamental shift in our energy landscape.

Now, the easiest thing an investor could do would be to invest in a broad-based ETF like the Select Sector SPDR - Energy (XLE), which will provide solid returns as the energy sector heats up.

But if you know where to look, greater profits are possible.

As you know, investing in exploration companies can be a real crapshoot. Even the successful companies tend to come up empty more often than not, and that can be devastating to an individual investor.

But with carefully selected ETFs, you can take advantage of specific pockets within the overall energy market. So long as you’re plugged in to the most important trends, this can be an exceptionally powerful tool.

If, for example, the supply/demand picture for natural gas presents an opportunity, you can invest in an ETF that focuses on the natural gas markets.

See related: Is Natural Gas Bottoming?

If you see that soaring demand for alternative energy will translate into life-altering profits for some companies, but you’re not sure which company will pop first, you can invest in ETFs that are devoted to specific niches of the alternative energy market.

In the last six months alone, you could have made 54% profits from a global energy ETF; 59.1% profits from a Canada-based natural gas ETF; and 31.4% profits from a solar energy ETF.

And I’m sure it’s possible that you could have made more by investing in specific companies that struck it rich during that time, but I also know that I wouldn’t want the risk associated with the old “needle-in-a-haystack” approach to energy investing.

That approach didn’t work for a good friend of mine…and probably a few friends of yours. The truth is, it’s an approach that works for only a very small number of individuals.

But thanks to the power of ETFs—in particular, the explosion in energy-focused ETFs—it’s now possible for you to exploit the unprecedented global demand for energy without the risk of lottery-style investing.

Now it’s worth remembering that energy, like all investments, is subject to short-term pullbacks from time to time. But those pullbacks are very small bumps in the road, as global demand for energy continues to soar. And the liquidity and diversification that ETFs provide help to minimize your exposure.

When used properly, ETFs allow you to actively trade the historic global shift in energy demand, while at the same time carefully managing your downside risk.

By R.J. Sterling, writer and financial publisher, ETF Energy Trader

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