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Go to the Bench for Oil Substitute

Roger Nusbaum

A way to use ETFs is as a substitute for a stock. If investors need to sell a stock for tax reasons they can switch into a similar ETF that captures most of the effect of owning the stock. Later on they can sell the ETF and buy the same stock back.

I made such a substitution trade Monday for clients, selling British Petroleum (BP Quote) and buying WisdomTree International Energy Fund (DKA Quote).

My clients have owned BP for several years. The case for BP is simple: It's a mega-cap, integrated oil company with a big presence in many emerging markets and has a very healthy 3.5% yield. BP has had more than its fair share of problems, including a deadly refinery accident in Texas for which it is being sued, a pipeline shutdown in Alaska and allegations of price fixing in various markets.

While the stock is down from its high, its year-to-date performance lags only slightly behind Total's (TOT Quote), another giant foreign energy stock. Longer term, I think BP is a worthy hold, but for the next six to nine months, the stock won't be able to outperform its sector.

WisdomTree International Energy seems the best proxy. First, BP is the largest single holding at 9.1% after the two different stocks for Royal Dutch Shell, which add up to 16% of the fund. If I am wrong about BP and the stock skyrockets, WisdomTree International Energy will clearly benefit. As with all WisdomTree funds, WisdomTree International Energy focuses on yield, and it pays 3.24%, almost as much as BP but with nowhere near the risk.

Another reason I chose WisdomTree International Energy is that I'm looking for foreign exposure, and most of the other energy ETFs have enormous positions in Exxon Mobil (XOM Quote), which is not a name I want to own. It is the biggest of the oil stocks by market cap, and usually the giants lag their sectors for most of the market cycle.

WisdomTree International Energy stacks up well by common valuation measures with BP. It trades at 10.95 times next year's earnings compared to 10.46 for BP, but WisdomTree International Energy is cheaper on a price-to-sales basis, 0.67 to 0.83, and price-to-book, 2.52 to 2.63.

U.K. companies make up the biggest part the fund at 27.4% of assets. Australia is second with 13% followed by Italy at 12%.

The fund has limitations that could make it less than ideal as the sole energy holding in a diversified portfolio. It is dominated by integrated oil companies. While there are drillers, service companies and other narrower stocks, their respective weights might not be enough to contribute meaningfully to the fund's performance.

There are also some countries important to the energy sector that are either not included or are very underweight. China is only represented by CNOOC (CEO Quote) at 3.38%, and Canada and Russia are omitted completely, which means very little emerging-market exposure and no oil-sands exposure. I think both of these themes are important.

Another potential bogey is the high Australian exposure at 13%. The two biggest Australian stocks, Woodside Petroleum and Santos, are lagging the Energy Select Sector SPDR (XLE Quote) by about 15% year-to-date.

It should be noted that the average volume for WisdomTree International Energy is a thin 5,600 shares a day, but low volume isn't an indication of poor liquidity where ETFs are concerned. ETF providers and the specialists who trade them do not want to be known for having products that can't trade. The key here is to use limit orders and have patience. I bought roughly 11,000 shares in two trades and there were 20,000 shares offered for sale by the specialist for the entire time that my orders were pending.