This Vanguard Sector ETF Yields 3%. Here's Why It's a Buy in August.

Want broad-based exposure to a theme but don't know where to begin? Sector exchange-traded funds (ETFs) may be right for you.

Sector ETFs offer a way to invest in an entire sector. For example, if you wanted to own a piece of hundreds of tech stocks -- from software to hardware to semiconductors and more -- there's the Vanguard Information Technology ETF . Vanguard has a low-cost ETF for all 11 sectors and they all have just a 0.1% expense ratio.

One that is worth a closer look right now is the Vanguard Energy ETF (NYSEMKT: VDE) , which has pulled back from highs earlier in the year, pole-vaulting its yield up to 3%. Here's why it stands out as one of the best sector ETFs now for generating passive income from dividend stocks .

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Betting on the best

The Vanguard Energy ETF invests in the entire oil and gas value chain, from upstream exploration and production (E&P) companies to oilfield services, midstream, refining, and the integrated majors. Despite having 115 holdings, the fund is heavily concentrated in just three companies -- with 22.4% in ExxonMobil , 13.5% in Chevron , and 6.7% in ConocoPhillips . However, being top-heavy in the oil and gas industry is probably a good thing.

To pay a stable and growing dividend, it's paramount that companies maintain strong balance sheets and grow earnings. In oil and gas, a strong balance sheet can help support a growing payout even during a downturn.

Unlike many of their European peers, ExxonMobil and Chevron did not cut their dividends in 2020 when the oil and gas prices were plummeting. ExxonMobil paid $14.9 billion in dividends despite booking a $22.4 billion loss and negative free cash flow. Meanwhile, Chevron lost $5.5 billion and $1.67 billion in free cash flow, which wasn't nearly enough to fund its $9.7 billion divined expense. But it paid it anyway using cash from the balance sheet and debt.

Not every company has the credit rating or dry powder to handle a capital commitment of that scale. Or worse, many companies take on debt just to keep business afloat, making them victims to the ebbs and flows of oil and gas prices.

ExxonMobil and Chevron also have diversified businesses. Their upstream portfolios are global and have low costs of production . Meanwhile, they also have sizable downstream businesses and are both investing billions of dollars in low-carbon efforts.

Given how well-rounded ExxonMobil and Chevron are, some investors may prefer to do a 50/50 split of both stocks. However, there are advantages of going with the Vanguard Energy ETF instead.

Cast a wide net

The 57% of the Vanguard Energy ETF that isn't in ExxonMobil, Chevron, or ConocoPhillips offers exposure to completely different links in the value chain. For example, midstream pipeline giant Kinder Morgan operates pipelines, storage, and other infrastructure projects that act as the arteries connecting regions of production to regions of processing, consumption, and export. Oilfield services companies make equipment, help producers drill and complete wells, and more.

Pure-play E&Ps offer arguably more upside potential from higher oil prices than behemoths like ConocoPhillips. Whereas ConocoPhillips has a global portfolio , some producers focus entirely on a single region. For example, 66% of Devon Energy 's production in first quarter 2024 came from the Delaware portion of the Permian Basin. And Devon is no small business, sporting a market cap of around $29 billion.

However, there are plenty of sub-$5 billion market cap oil and gas companies. The Vanguard Energy ETF is one of the simplest ways to gain exposure to dozens of these types of companies without letting those positions dominate the performance of the fund.

What's more, spreading the allocation out across so many different smaller companies protects against bankruptcy risk. The weighting of the bottom 50% of fund companies each have less than a 0.2% weighting in the fund and the smallest ones have just a 0.04% weighting.

A good value

The Vanguard Energy ETF stands out as a particularly good buy in August because of its valuation. The fund sports a mere 8.2 price-to-earnings (P/E) ratio -- which is less than a third of the S&P 500 's P/E ratio.

Granted, assessing energy stocks solely on their P/E ratios is a bad idea since earnings can fluctuate based on oil and gas prices. However, many companies are well-positioned to thrive at current oil prices.

Moreover, companies with high leverage ratios have taken advantage of outsized gains to shore up their balance sheets. Occidental Petroleum , for example, has seen its debt-to-equity ratio go from nearly 2 four years ago to just 0.29 today.

So, while it's unlikely the industry will be able to match its outsized gains from 2022, it is well-positioned to put up solid results at current prices or even endure a downturn thanks to strong financials.

Get your feet wet in the oil patch

When it comes to sector ETFs, the Vanguard Energy ETF is arguably one of the most well-constructed. It gives exposure to the integrated value chain while allocating heavily toward the highest-quality companies. There are multiple holdings from each industry, which can be useful if one major player is undergoing self-inflicted challenges. And finally, the fund has a good yield and is low cost, with just $10 in fees for every $10,000 invested.

Add it all up, and the Vanguard Energy ETF is a great way to invest in the oil and gas industry and collect passive income in the process.

Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chevron. The Motley Fool recommends Occidental Petroleum. The Motley Fool has a disclosure policy .