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By Paul Justice, CFA | 01-06-2010 05:04 PM

Another Way to Play Natural Gas

First Trust's Eric Anderson talked to Morningstar's Paul Justice about the ISE-Revere Natural Gas ETF, which invests in natural gas-focused equities.

Paul Justice: Hi, I'm Paul Justice, ETF strategist with Morningstar. Today I'm joined with Eric Anderson from First Trust. Thanks for joining me, Eric.

Eric Anderson: Yep. Thanks, Paul.

Justice: Things have been heating up in the energy sector, especially in natural gas. We know that a lot of investors had invested in the United States Natural Gas Fund on the commodities side, but we've also seen a lot of interest in equity-based natural gas producers. You happen to manage one the fastest-growing funds in this area, the ISE-Revere Natural Gas Index. Could you tell us about this fund a little bit and how it's constructed?

Anderson: Sure. FCG is the ticker. And it's really been one of our fastest-growing ETFs in our complex. As of last night, we have over $500 million in assets. But one thing that I would like to highlight, FCG is very different than other natural gas offerings that are out there. We're going to be investing in the equity stocks that are involved in the natural gas space. So what you're going to end up getting exposure to are explorers and producers within the energy sector.

You mentioned we partner with the ISE in the index construction. They really maintain the index and drive what the portfolio is going to look like on a quarter-to-quarter basis. And really the main factor that they're going to be looking at is the exposure that explorers and producers have to natural gas. They're really looking for companies that are focused on natural gas.

Frequently in that energy space you'll find the E&Ps are involved, not just in natural gas, but in oil and others.

Justice: Yeah, you drill a hole and whatever you find.

Anderson: You drill a hole and whatever comes out, that's what you're going to produce. But there are stocks out there, there are equities out there, that are more focused on natural gas. And they're more involved in the technology, such as horizontal drilling, that's more unique to natural gas. So really what they're looking for are revenues or reserves that are more than 50% of their book coming from natural gas. That's really what's going to drive the selection.

After that, the ISE picks the top 30 stocks, and they're going to equally weight them.

Justice: Now if the fundamentals of the companies aren't changing all that often, do you get a lot of turnover if you're turning it over every quarter?

Anderson: There will be turnover from a perspective of you're re-weighting to the equal weighting at the beginning of each quarter. But other than that, there isn't going to be a lot of adds and drops. I'd say maybe three or so per quarter, throughout the 30. It may change over on a quarterly basis. But most of your turnover is really going to come from the re-weighting.

Justice: You may take on some different risk factors and get a different return profile than, say, a cap-weighting strategy, even if you identify the same companies. Would you mind talking about that a little bit in comparison to, say, a market-cap-weighted fund?

Anderson: Sure, definitely. Any time you equally weight a strategy or a portfolio, you're going to end up with a smaller capitalization bias. So there is going to be a little bit of that in there. We think that's part of what you want when you're investing in natural gas E&P companies, broad exposure to those E&Ps. Because it may be the smaller company that drills a hole and finds a great reserve. It's not necessarily the larger ones. So it's definitely something we want exposure to.

Justice: So it's a different return dynamic. It's not necessarily better or worse.

Anderson: Right. I'd say there's a lot of other factors that are involved in natural gas investing through the equities. You have M&A activity.

Justice: Which has been very hot.

Anderson: Which has been very hot. And you have a lot of other--credit markets tend to play a little bit more of a role, because you're dealing with capital structures within those equities that invariably are tied to fixed income to some degree. A lot of times you'll find that the E&Ps are more leveraged to the price of natural gas, or on the oil side to the price of oil.

Justice: Well, for investors who are looking at one way to play energy, this seems like a very good way in the natural gas space, especially if you're looking for a little bit more, I guess, extra return for a little bit of extra risk.

Anderson: Yep, definitely.

Justice: With that, I'm Paul Justice with Morningstar, and it was my pleasure to be joined by Eric Anderson.

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