DRLL: Drilling A Duster

seekingalpha08-24

Strive U.S. Energy ETF may have changed its mandate, as its 'anti-ESG' proxy-voting guidelines are no longer in its prospectus.DRLL has consistently underperformed peer broad energy funds like XLE and...

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Gunter Nuyts/iStock via Getty Images In Oil & Gas Industry slang, 'drilling a duster' refers to a dry hole, with no economic quantities of hydrocarbons. The more I analyze the Strive U.S. Energy ETF (NYSE:DRLL), the more I am reminded of this slang. Last year, when I initiated coverage on the DRLL ETF, I questioned the differentiation factor between DRLL's portfolio methodology and cheaper alternatives like the Energy Select Sector SPDR Fund (XLE). Furthermore, I showed that DRLL's much-hyped corporate governance strategy was not materially different from how other ETF managers vote on ESG issues. In this article, I want to review changes to DRLL's mandate, as well as the fund's performance, since the fund has been in operation for over 2 years. In April, DRLL changed its reference index from the Solactive United States Energy Regulated Capped Index TR to the Bloomberg US Energy Select Index. More importantly, the fund's updated prospectus has removed references to the fund's 'anti-ESG' proxy-voting guidelines. Has Strive 'sold out' in order to increase assets under management? Furthermore, there is a persistent underperformance of DRLL relative to its peer broad energy funds. Since its inception, DRLL has underperformed by a cumulative 12-13%. With its questionable mandate and poor performance, I continue to recommend investors avoid this fund. Brief Fund Overview The Strive U.S. Energy ETF's claim to fame is the asset manager's founder, Vivek Ramaswamy. Mr. Ramaswamy rose to national prominence based on his 'anti-woke' political stance. The DRLL ETF's stated goal is to \"unlock value in the U.S. energy sector by mandating companies to focus on excellence\" over politics (Figure 1).   Figure 2 - DRLL fund mandate (DRLL factsheet) Strive Asset Management aims to “prioritize the shareholder over other stakeholders” by rejecting large asset managers' tendency to “[incorporate] non-pecuniary factors under the guise of considering environmental, social, and governance risk factors.” The DRLL ETF is marketed to investors fed up with ESG proposals that have been \"crammed down investors’ throats by fund companies and the media”. DRLL currently has $324 million in AUM and charges an expensive 0.41% expense ratio (Figure 2).   Figure 2 - DRLL overview (strivefunds.com) Peer funds like the XLE ETF and the Vanguard Energy Index Fund ETF (VDE) charge 0.09% and 0.10% respectively (Figure 3).   Figure 3 - DRLL is more expensive compared to peers (Seeking Alpha) Dropping Anti-ESG Voting Policies From Prospectus? In my prior article, I noted that one of DRLL's 'features' is the fund's 'anti-ESG' proxy voting guidelines. As listed in the fund's original prospectus, the DRLL ETF will use its proxy voting powers to vote \"in favor of board members and proposals that the Firm believes will lead companies to be mission-driven, customer-centric, innovative, merit-based, and financially disciplined.\" The DRLL ETF \"will vote against proposals and board members that the Firm believes will not best advance these objectives.\" However, on April 11, 2024, the DRLL ETF switched its fund benchmark from the Solactive United States Energy Regulated Capped Index TR to the Bloomberg US Energy Select Index. Along with its reference index change, the fund's updated prospectus no longer includes the specific proxy voting guidelines. While the dropping of the proxy voting guidelines may be a filing oversight, it could also reflect a change in the fund's mandate. According to Strive's new CEO, Matt Cole, Strive has been seen as overly political, \"turning off some investors and limiting its opportunities to grow.\" The firm needed to \"recalibrate[s] its anti-woke meter\" to grow assets under management. In other words, Strive may have 'sold out' its 'anti-ESG' investor base. DRLL Sells A Catchy Story... Instead of focusing on the politics and culture war, Mr. Cole wants investors of DRLL to focus on the attractive investment opportunity available in U.S. energy companies. According to JPMorgan analysts, a growing shortfall in oil and gas investments could lead to a spike in energy prices and bonanza profits for the industry. Fundamentally, energy companies trade at less than half the S&P 500 Index's P/E but have grown earnings by almost 5x that of the market in the past 4 years (Figure 4).   Figure 4 - Energy companies have grown earnings faster than the market (DRLL investment case) On a relative basis, Strive believes energy company valuations are structurally cheap compared to the technology sector. A reversion to the historical average could see energy valuation multiples expand by 3.5x (Figure 5).   Figure 5 - Strive believes energy sector multiples can expand by 3.5x (DRLL investment case) ...But Parity May Be Wishful Thinking... With respect to valuations, I have to agree with the managers at Strive. The U.S. Energy Sector, trading at a Fwd P/E of ~12x, looks compelling relative to the market at 21x (Figure 6).   Figure 6 - Energy Fwd P/E looks compelling (yardeni.com) However, one caveat against the multiple expansion thesis is that the Energy sector is notoriously cyclical, with operating earnings often dipping into negative territory during economic slowdowns and recessions (Figure 7). So it may be wishful thinking to believe Energy should trade at parity relative to Technology, which has seen pretty much uninterrupted growth in earnings.   Figure 7 - Energy sector operating earnings are highly cyclical (yardeni.com) ...And Is DRLL The Right Instrument To Capture Energy Upside? Furthermore, there is the question of whether DRLL is the best-suited investment to capture upside in the Energy sector. In my last article, I noted that DRLL had underperformed the XLE and VDE ETFs by a few percentage points since inception. Unfortunately, the performance gap has widened to a chasm in the last year, as DRLL's performance has continued to lag, with DRLL returning 0.3% compared to 6.6% for XLE and 5.8% for VDE (Figure 8).   Figure 8 - DRLL vs. XLE and VDE, 1-year performance (Seeking Alpha) This has widened DRLL's since-inception underperformance to over 13%, with DRLL returning 15.0% compared to XLE at 28.2% and VDE at 27.1% (Figure 9).   Figure 9 - DRLL vs XLE and VDE, since inception returns (Seeking Alpha) Looking through the details, it is unclear why DRLL is underperforming by so much, since DRLL's top holdings (Figure 10) are very similar to that of XLE (Figure 11) and VDE (Figure 12).   Figure 10 - DRLL top 10 holdings (strivefunds.com)  Figure 11 - XLE top 10 holdings (ssga.com)  Figure 12 - VDE top 10 holdings (vanguard.com) Conclusion In summary, the Strive U.S. Energy ETF claims to unlock value through superior corporate governance practices. However, an analysis of DRLL's updated prospectus suggests the fund may have changed its proxy-voting guidelines to be less 'anti-ESG'. Furthermore, looking at DRLL's performance, we see an inexplicable perpetual underperformance relative to more established, cheaper alternative funds like the XLE and VDE.  Even though I am personally bullish on the Energy Sector's relative valuation, I would not recommend investors express it through the DRLL ETF. 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