As you pay more for gas and heating oil, energy stocks and the funds that invest in them are enjoying a tremendous run, but financial professionals say you should consider the risks carefully before you load up on this hot sector.
On Wall Street, what goes up invariably must come down, which makes chasing performance a dangerous strategy -- you may make the classic blunder of buying high and selling low. Sector funds are volatile in general, but few parts of the market are as volatile as energy, said Jack Brod, principal of asset management services at the Vanguard Group Inc.
"It's an investor behavioral trap that recent performance tends to attract a lot of attention, and clearly the energy sector has been providing extraordinary returns over the past several years," Brod said. "We are just trying to encourage investors to be thoughtful about why they select funds."
While Vanguard offers a wide range of specialty funds -- including the Vanguard Energy Fund (VGENX), which has seen its share price rise more than 50 percent in the past year -- they aren't for everyone, Brod said. For most individual investors, it's simpler and far less risky to build a diversified portfolio without them.
"Sector funds can be extremely volatile and can behave more like an individual stock than a fund," Brod said. "They may have their place, but we recommend investors step back and take a look at their existing portfolios. They may not realize the stock funds they have may already have exposure to the energy sector."
If you've held a broad market fund for more than a couple of years, your energy stake has already been on the rise. The 29 energy stocks in the Standard & Poor's 500-stock index make up almost 10 percent of the cap-weighted index, up from 5.8 percent at the end of 2003. Energy stocks have historically accounted for about 8.28 percent of the index, according to S&P.
Year-to-date, the sector has surged almost 36 percent. That follows a rise of 28.77 percent last year and 22.4 percent in 2003.
"We haven't seen a run-up like that, God help me, since technology," observed Howard Silverblatt, editor of quantitative services for S&P.
Tech stocks, which now account for 15.36 percent of the S&P, swelled to 34.51 percent at their height, on March 24, 2000. Then, as now, investors were eager to take advantage of the sector's run, which had lasted for years and seemed like a sure thing.
If you're in the market for the long haul, limited exposure to commodities can bring valuable diversity to your stock and bond portfolio. But it's important not to see natural resource funds as a way to place a short-term bet. Fund-tracker Morningstar Inc. selected its pick in this area with long-term investors in mind, recommending PIMCO Commodity Real Return Strategy (PCRAX) because it's among the few funds that provide direct exposure to a broad set of commodities, from oil and gas to cattle and coffee.
Analysts have been warning for a while now that the energy sector is looking frothy, but the sell decision can be tricky. Despite their precipitous rise, energy stocks remain attractively valued relative to the rest of the market. And the fact that many pay dividends could help ease the sting for shareholders if they fail to maintain their earnings.
But experts say you may regret taking a larger stake in an energy fund when oil prices correct.
"We have thought there's reason for caution for a while now," said Elizabeth Ann Sonders, chief investment strategist at Charles Schwab Corp., which lowered its recommended energy allocation from overweight to market-weight several months ago.
"We told investors if they are long-term investors, this is not a sell recommendation, but if they had outsized positions in energy . . . they probably want to pare back some of those gains," she said. "We've advised near-term caution in the context of a long-term positive view."
One of the things that has Sonders a bit edgy in the short term is that sentiment indicators suggest unprecedented levels of optimism about energy stocks on the part of traders and portfolio managers. Excessive confidence, fueled by speculation, can lead to market extremes, which are generally followed by a retreat. But Schwab is not negative on the sector because the valuations still appear reasonable.
"I wouldn't chase them here," Sonders said. "You want to participate in this, but avoid the greed. If you've been lucky enough or smart enough to be in energy, maybe pare back, but I wouldn't pare back beyond market-weight."
Maintaining smart diversification and rebalancing as you go are key, Sonders said. Recalling the bubble in tech, and how many investors were harmed because their exposure to the sector had swollen to such substantial levels, she said, "If you're at normal exposure, you're going to withstand a correction better than if you rose with your gains and let your exposure get up to lofty levels so that when the turn comes you're holding a big energy bag."