This Top Energy ETF Holds 112 Stocks. But These 2 Make Up Over 33% of Its Holdings.

One of the great things about investing in exchange-traded funds (ETFs) is that they provide instant diversification across a market or sector. Many hold 100 or more stocks. That diversification helps reduce risk.

However, not all ETFs are as diversified as they seem. While the Vanguard Energy ETF (NYSEMKT: VDE) holds 112 energy stocks, two of those holdings -- ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) -- comprise more than a third of the total. That's an important factor investors need to evaluate when considering this ETF.

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Top heavy

Vanguard Energy ETF enables investors to passively invest in the energy sector. The ETF seeks to track the performance of a benchmark index, the MSCI US IMI Energy 25/50, that measures the returns of energy stocks. That benchmark holds 111 stocks, one less than the Vanguard Energy ETF. However, they both have very similar allocations to the same energy stocks.

ExxonMobil is the top holding, at about 21% of the ETF's assets. Chevron is second, at 13.5%. That's a third of the fund's holdings in just two energy stocks. Meanwhile, the fund's 10 largest holdings comprise 62.7% of its assets.

On one hand, that's a lot of concentration at the top, and the returns of ExxonMobil and Chevron will have an outsize impact on those the ETF produces. We've seen that over the past year, as the fund's returns have largely followed the prices of its top two holdings:

VDE data by YCharts

However, given the strength of those two oil giants, the fund's outsize exposure might not be a bad thing.

The king of the oil patch

ExxonMobil isn't just the country's largest oil and gas producer; it's the industry leader in almost every financial metric that matters. Last year, Exxon produced $34 billion in earnings and $55 billion in cash flow from operations, which led all international oil companies. Exxon has also delivered peer-leading growth rates of 30% for earnings and 15% for cash flow over the past five years. A crucial factor driving earnings growth has been the $12.1 billion of structural cost savings it has achieved, which is significantly higher than its competitors. Exxon has also delivered peer-leading returns on capital employed, at an 11% average over the past five years, and total returns, with a 14% compound annual growth rate over the same period. To top it off, Exxon has the sector's best balance sheet even after returning a whopping $150 billion in cash to shareholders through dividends and repurchases.

The big oil company expects to continue building on its leading position over the next several years. Exxon's 2030 plan would see it add $20 billion in earnings and $30 billion in cash flow by 2030. It aims to achieve this growth by continuing to capture structural cost savings totaling $7 billion more while investing heavily to grow its advantaged assets, which are those that earn the highest returns. That positions Exxon to produce $165 billion in surplus free cash flow through 2030 after investing $140 billion into major projects and its Permian development program. Its rising cash flow will give it more money to return through its dividend, whish has grown for an industry-leading 42 straight years, and share repurchases.

A strong No. 2

Chevron doesn't make as much money as Exxon, with $18 billion in earnings and $31.5 billion in cash flow. But it's still a strong oil company. Last year, it delivered record production and returned a record $27 billion in cash to shareholders. Meanwhile, it has a very strong balance sheet, with its net debt at 10.4%, well below its 20%-25% target range.

Furthermore, like Exxon, Chevron expects to deliver meaningful earnings and cash flow growth in the coming years. It plans to produce industry-leading free cash flow growth of over $10 billion by 2026, fueled by major project ramp-ups, continued growth in the Permian Basin, and its structural cost savings program. Meanwhile, there's additional upside potential from its needle-moving acquisition of Hess, which it hopes to close later this year if it wins its arbitration hearing against Exxon. The company's surging free cash flow will give it even more money to return to shareholders through a growing dividend and meaningful share repurchases.

A very strong Top Two

ExxonMobil and Chevron comprise over a third of Vanguard Energy ETF's assets. While that is somewhat concerning because it ties the ETF's returns to those two oil stocks, they're two of the best oil companies in the world. So it's still a good ETF to buy for energy stock exposure, especially since that duo is so vital to the sector.

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Matt DiLallo has positions in Chevron. The Motley Fool has positions in and recommends Chevron. The Motley Fool has a disclosure policy.