Energy mutual funds are a way of investing based upon the stocks of companies that produce energy or are otherwise involved in the energy industry. As with all mutual funds, they involve the money of multiple investors being collected together and used by a fund manager to buy and sell stocks and other financial products, with the profits split proportionally between the investors. This set up allows investors to benefit from economies of scale, such as reduced transaction costs when the fund manager buys and sells, and the ability of the fund manager to get better deals in the stock market by being able to buy and sell in bulk.
The main theory behind the attractiveness of energy mutual funds is that they are based on a stable industry. Because energy is something of a basic need rather than a desire, energy companies are much less susceptible to short-term changes in demand and tastes. The big drawback with energy companies is that one of the factors that can cause a rapid drop in value, an environmental disaster, is both unpredictable and severe in its financial effects. There are also questions about the ability of major energy firms to deal with long-term trends in the industry, such as oil supplies diminishing. That said, this may not affect the relatively short-term investments associated with mutual funds.
Like any other type of mutual fund, energy mutual funds operate in a wide variety of ways. Some fund managers personally choose which stocks to buy and sell, based on informed intuition. Others run fully automated funds where a computer decides when to buy and sell using a pre-determined objective formula. Most fall somewhere in between the two.
One variation that is becoming more popular is alternative energy mutual funds. These specialize in companies engaged in non-traditional forms of energy, such as solar or biofuel. As a general rule, such forms of energy are considered either less harmful to the environment than traditional energy sources, renewable and thus a better long-term proposition, or both.
There is an argument that such sources, particularly when not well established, have high up-front costs and take a long time to earn back these costs. This can limit the short-term profitability of these companies and thus their stock values. For this reason, alternative energy mutual funds are often chosen as much on ethical and social grounds as for their money-making potential.