Green ETFs – how to choose?

UPDATE: Jan 2009: Here’s a more recent look at the (now 13) available green energy exchange traded funds

In January, index investors will have a second Clean Energy Index fund to chose from. First Trust Advisors L.P. has licensed the NASDAQ Clean Edge U.S. Liquid Series Index, for clean-energy investors, in order to launch a new exchange traded fund (ETF).  (See full article on Renewable Energy Access.)

The new ETF will trade on NASDAQ as CELS, and joins the Powershares Wilderhill Clean Energy Portfolio,which trades on AMEX as PBW, and was launched in March of 2005, as well as Powershares’ recent launches of PowerShares Cleantech Portfolio (PZD) and PowerShares Progressive Energy Portfolio (PUW), and Market Vectors Environmental Services ETF (EVX).

 With so many new “Green” ETFs popping up,  Richard Kang rightly asks “At what point do we have so many ETF offerings that we call this an “ETF bubble”?” on SeekingAlpha.  I agree with him that we’re not there yet

For investors interested in clean energy, who do not have the time or expertise to pick stocks in the field, the question is which ETF to use, or should we use a little of each for diversification?

Criteria to consider are:

  1. Expense ratio.
  2. Index composition.
  3. Index weighting.
  4. Turnover
  5. Availability and liquidity of exchange traded options.

The ETF structure provides assurance that all are liquid; that is an investor can be reasonably assured of getting near the market price even for very large orders.

1. Expense ratio.  This is how much investors pay the management company on an annual basis for maintaining the fund, and the lower the better.  One great advantage of the ETF structure is that it allows for very low expense ratios, but most of these ETFs have relatively high expense ratios for the ETF space.  Expense ratios are: PBW .71%; PZD capped at .6%; PUW capped at .6%, and .55% for EVX. 

2. Index Composition. PBW and CELS have a purer emphasis on Energy Efficiency and Renewable Energy than do PZD, PUW and EVX, which focus on knowledge based products for improving efficiency and reducing waste, more efficient use of fossil fuels, and environmental services.   Purer “green” investors may shy away from PUW with its emphasis on fossil fuel based technologies, while investors who are more motivated to invest in EE/RE because they anticipate rising energy prices rather than wishing to do something about global warming will be more likely to gravitate towards PZD and PUW, while investors most interested in environmental cleanup will gravitate towards EVX. 

Investors can gain diversification advantage by adding EVX and PUW to any of the others, but PBW, CELS, and PZD all seem fairly similar to me, and the added transaction costs make it hard to justify having more than one (or two at the most) of the above in a portfolio.

3.  Index Weighting.  CELS is based on a capitalization weighted index, EVX on a dollar weighted index, and PBW and PUW are based on modified equal-weighted indecies, while PZD is weighted by Sector.

The choice of capitalization weighting (CELS) seems like a bad idea to me in this sector, because the largest companies involved are ones like GE, which have considerable operations outside the sector, and so the ETF may not end up being very representative of the sector.  [note: read Joel Makower’s comment below- it turns out that the Clean Edge index will be dealing with this problem in an elegant manner.]

In addition [Joel’s comment again,] the Clean Edge Index only includes “pure play” stocks, so conglomerates like GE won’t be around to mess things up, as in my example above.  The choice of wether to include non-pure play companies is a tough one, since many of the leaders in the sector are conglomerates (i.e. Sharp in PV, GE in wind turbines (at least in terms of US-listed companies), but in the end choosing pure play companies only is probably the best choice for a sector fund.) 

Dollar weighting (EVX)  also seems like a perverse choice to me, because this gives greater weights to companies with higher stock prices, and stock price (as opposed to market capitalization or float) is not a reliable measure of anything.

I like sector weighting (PZD) and modified equal weighting (PBW and PUW) for their benefits to diversification.

4. Turnover.  Turnover is how much the contents of a fund change over time.  In general, we want low turnover in an ETF, because that means we are less likely to receive unexpected capital gains distributions, and will probably have lower expense ratios.  Of the currently existing funds, Turnover ratio for PBW is 6%, but the others still need more operating history before we’ll know. 

5. Avialability and Liquidity of exchange traded options.  This will only be an issue for more sophisticated investors who like to use options for various hedging strategies.  Of the funds considered, PBW is the only fund with a significant number of listed options, and trading is starting to pick up, so options on PBW are now becoming viable for hedging.  The others have no or negligible exchange traded options available, but that could change quickly given how new these funds are.

Overall, I still prefer PBW to the newer pretenders to the throne, because of the better choice of weightings EVX, and because I like to use cash covered puts and covered call strategies, for which I need the availability of exchange traded options.  There may also be some role for PZD and PUW for increasing diversification. 

CELS is still a wild card, but I’ll likely begin to prefer it to PBW if they come in with an expense ratio below .7%.  The whole point of ETF investing is diversification and liquidity without high costs.

In the end, I will not end up using any of these funds for my own or client portfolios, however, because I feel that given the lack of generally available good information about the sector, an insider can make informed decisions to increase market returns.   Another advantage of individual stock picking is that it allows the inclusion of conglomerates such as GE, Johnson Controls, and Sharp, who are market leaders in various parts of the EE/RE marketplace.  The smaller pure play companies are much less appropriate for risk adverse investors, and have good chances of losing out to the big guys.

For other investors interested in stock picking in the sector, examining the components of the indecies these ETFs are based on can be a good place to start when considering companies to research, but don’t neglect the conglomerates.

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5 Comments

  1. Thanks, Tom, for covering CELS — the forthcoming ETF based on the NASDAQ Clean Edge US index. I wanted to clarify a few things.

    With regards to your criteria #3 on index weighting:

    Our weighting structure is a modified market-capitalization with the largest components capped to ensure no index domination by any individual components. We are also a pure-play, with no utility companies or multinationals not primarily focused on clean energy (so GE, per your example, would not qualify for the CELS index).

    The weighting of CELS components was partially designed to ensure index liquidity so CELS can act as an underlying index for any number of financial products.

    Joel Makower
    Co-founder and Principal
    Clean Edge, Inc.

  2. I’m trying to decide on a good alternative energy ETF right now. Thanks so much for this post – it clarified a lot of things for me. Just discovered your site and I’m learning a lot… thanks!

  3. […] information, Renewable Energy, investing, mutual funds New Alternative energy Mutual Funds and ETFs have been popping up like mushrooms after a rainstorm, so I’ve updated my previous […]

  4. Ashley McArthur said

    Dear Dr. Conrad,

    I am writing to let you know about an idea being floated by Green America for a new investment option, Clean Energy Victory Bonds (CEVB). Modeled after WW2 Victory Bonds, CEVB would be used to fund renewable energy projects and other energy saving measures. More info can be found here: (http://www.greenamericatoday.org/programs/climate/CEVB/)

    We hope you’ll find this idea interesting, and would be happy to answer any questions you might have. If you can support us by including a brief summary of CEVB on your blog, it would help us get the word out to Americans that CEVB are in the works.

    Many thanks,
    Ashley

    Ashley McArthur
    Green America, Climate Action Program
    amcarthur@greenamericatoday.org

  5. Harold Davidson said

    Check out the EasyETF on the FTSE Environmental Opportunities 100, it has much larger more diversified environmental technology companies that must generate over 20% from environmental technology business.

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