XEG ETF: Is Diversification an Illusion in Canada's Energy Sector?

The iShares S&P/TSX Capped Energy Index ETF (XEG) has long been a go-to vehicle for investors seeking exposure to Canada's energy sector. Marketed as a diversified index fund, XEG's structure appears to offer broad access to the sector's leading companies. Yet a closer look reveals a stark reality: the fund's top two holdings-Canadian Natural Resources Limited (CNQ) and Suncor Energy Inc. (SU)-account for nearly half of its portfolio, with CNQ alone representing over 24% of assets according to holdings data. This concentration raises a critical question: does XEG truly deliver diversification, or does its structure amplify risk in a sector already prone to volatility?

The Illusion of Diversification

Energy markets are inherently cyclical, driven by commodity prices, geopolitical events, and regulatory shifts. A fund like XEG, which tracks the S&P/TSX Capped Energy Index, is designed to mirror the performance of the sector's largest firms. However, its heavy weighting toward a handful of companies undermines the diversification benefits typically associated with index funds. For instance, CNQ and SU together constitute 48.6% of XEG's portfolio, while the top 10 holdings account for over 80% of the fund according to TradingView analysis. Such concentration means that XEG's performance is disproportionately tied to the fortunes of a few firms, exposing investors to idiosyncratic risks that a truly diversified portfolio would mitigate.

This risk was starkly evident during the third quarter of 2024, when XEG lost 6.32%, underperforming the average energy equity fund's 2.78% decline according to Morningstar data. The downturn coincided with a sharp drop in oil prices, a scenario where a diversified portfolio might have softened the blow. Instead, XEG's concentration amplified losses, as CNQ and SU-both major producers-were hit hard by falling commodity prices.

Active Management: A Counterpoint to Concentration

Active funds, by contrast, offer a different approach. The BMO Equal Weight Oil & Gas Index ETF (ZEO), for example, distributes investments equally among 15–16 stocks, ensuring no single holding exceeds 8.25% of the portfolio. This structure reduces exposure to individual company risks while maintaining sector-wide participation. Similarly, the Ninepoint Energy Fund (NNRG), an actively managed vehicle, focuses on mid-cap energy firms, which may offer growth potential but at the cost of higher volatility and fees.

While active management comes with higher costs-NNRG charges a 1.5% base fee and a 10% performance fee-its flexibility allows managers to adjust holdings in response to market shifts. A 2024 study of energy equity funds found that skilled managers could outperform benchmarks during volatile periods, particularly post-2021, when the sector rebounded from the pandemic-driven crash according to MDPI research. However, active strategies are not without drawbacks. NNRG's performance, for instance, lagged behind XEG's 14.77% annual return in 2025 according to Morningstar data.

Performance in Downturns: A Test of Resilience

The 2020 oil crash offers a telling case study. During the recovery phase, XEG surged 317% over 22 months, capitalizing on the sector's rebound according to Yahoo Finance. Yet this same concentration proved a liability in Q3 2024, when the fund's 6.32% loss underscored the sector's vulnerability to sudden price swings. Active funds fared no better: the Global X Pipelines & Energy Services Index ETF, for example, fell 2.89% in August 2024 according to Morningstar data. These episodes highlight the sector's inherent volatility, which neither passive nor active strategies can fully insulate investors from.

The Efficiency Paradox

XEG's efficiency in capturing broad sector gains is undeniable. By December 2025, the fund had delivered a year-to-date return of over 20%, outperforming many active counterparts. Its low expense ratio and liquidity make it an attractive option for investors seeking simplicity. Yet efficiency comes at a cost: the fund's structure prioritizes market exposure over risk management. In contrast, active funds like ZEO and NNRG trade some returns for diversification or strategic positioning, albeit with higher fees and variable performance.

Conclusion: Balancing Risk and Reward

For investors, the choice between XEG and active energy funds hinges on risk tolerance and market outlook. XEG's concentration offers the potential for outsized gains in bull markets but exposes investors to significant downside in downturns. Active strategies, while more costly, may provide better risk-adjusted returns in volatile environments, though their performance is far from guaranteed.

As the energy sector continues to evolve-shaped by the transition to renewables, regulatory pressures, and technological innovation-the question of diversification will only grow more pressing. For now, XEG remains a compelling option for those who prioritize market exposure over risk mitigation. But for investors seeking true diversification, the answer may lie beyond the confines of a single ETF.