Exposure to the Hard-Hit Energy Sector, at a Low Cost

This portfolio is top-heavy. It's dominated by a pair of heavyweights: vertically integrated supermajors

Energy-market volatility has had a major impact on United States equity-market performance in recent years. That has made this fund far more volatile than the broader market. For example, over the past 10 years, this ETF's standard deviation of returns of 22.0% is far higher than the 15.1% posted by the S&P 500. And XLE's three-year standard deviation of returns of 17.2% also far eclipses the 10.9% logged by the broad benchmark. Within this fund, some of the greatest volatility can be found in the performance of energy exploration and production firms and oil-services companies such as

Over the years, XLE's diversification potential seems to have been eroding. Over the trailing 15-year period, XLE has been 66% correlated with the S&P 500. However, over the trailing 10- and five-year periods, its correlation to the S&P 500 has increased to 72% and 78%, respectively. Still, XLE remains an effective tool for investors seeking an overweighting to the energy sector within a broadly diversified portfolio. The energy sector currently makes up about 6.5% of the S&P 500. Keep in mind that as a U.S. sector fund, XLE does not hold international supermajors such as

Fundamental View Energy-price volatility has become the new norm. After years of stagnant oil production, oil supply has risen dramatically, as U.S. producers have continued to bring new supply online, particularly in the Bakken and Eagle Ford Formations, owing largely to new drilling methods, such as hydraulically fractured, tight oil wells. Members of OPEC have responded by staying the course--keeping output steady in an attempt to maintain their market shares. Meanwhile, China's previously strong oil demand has fallen amid a deceleration in economic growth. The upshot is that the world is awash in oil and prices have plummeted. U.S. natural gas prices also have been held low amid abundant supply. This combination of oversupplied oil and gas markets has meant considerable recent pain for the firms found in this ETF, particularly those in the exploration and production space.

There appears to be no such thing as a "steady state" when it comes to commodity prices, and investors shouldn't expect oil and gas markets to remain oversupplied forever. While predicting very short-term commodity-price movements is extremely difficult, Morningstar's equity analysts see no immediate relief to this period of oversupply and in fact take the position that current crude oil prices currently are well below the levels required to encourage sufficient investment to meet demand beyond 2017. However, for investors taking a medium- or long-term view, there are several potential signs of hope for the energy sector.

First, ailing energy producers in the U.S. are reducing their upstream capital spending again in 2016 as they did in 2015. Lower investment should mean less output, which over time could contribute to a rebalancing of the markets. In addition, less oil-directed drilling activity theoretically could mean lower growth in U.S. natural gas production. And while it's far more difficult to place a probability on such events, a far more immediate impact on energy prices could come from some geopolitical event involving a major oil-producing nation or alternately, Saudi Arabia finally crying uncle and cutting oil production, thus abandoning its ongoing quest to hold market share.

Given that Exxon Mobil makes up such a large portion of this ETF, it's worth discussing its outlook. Exxon has distinct and sustainable competitive advantages, as evidenced by the fact that Morningstar's equity analysts award Exxon a wide Morningstar Economic Moat Rating. Exxon’s wide moat comes from its integration of its low-cost upstream and downstream businesses and its low cost of capital. (By contrast, refining operations generally offer no moat, since refiners produce a commodity product in a highly competitive market with no pricing power.) While Exxon responded to the slowdown in energy prices by reducing capital spending, it may need to increase spending within several years to maintain production. In addition, should oil prices remain low for an extended period of time, Exxon may well need to increase debt to avoid reducing share repurchases and slowing dividend growth.

Portfolio Construction

This ETF holds the 40 oil and gas and energy-services companies found in the S&P 500. These firms make up the energy sector's entire 6.5% weighting in the S&P 500. The weightings of each stock correspond roughly to each stock's market cap. Thus Exxon Mobil, the largest oil company in the world, makes up about 21% of assets, and the top 10 holdings soak up more than 68% of assets. Constituents are leading U.S. companies that meet S&P's profitability criteria. These criteria eliminate non-U.S. oil companies, including Royal Dutch Shell,

Fees Sector SPDR ETFs are among the cheapest and most-liquid sector funds available. The fund's 0.14% expense ratio is low even by ETF standards.

Alternatives

The pricier

VDE and FENY provide more diversification, but are just as top-heavy as XLE. By including of smaller energy firms, VDE and FENY have posted slightly higher standard deviations over the past two years than XLE and IYE.

For international energy exposure, investors can consider

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