Renewable energy ETFs: buyer beware

Renewable energy ETFs: buyer beware

Renewable energy will be a major growth industry over the next several years. Demand for solar, wind, and other renewables like biofuels continues to rise. The prospect of generating clean, unlimited amounts of energy is very attractive from an environmental perspective. And, thanks to a significant reduction in costs over the past several years, use of renewable energy makes great economic sense as well.

For investors looking to get in on the ground floor of the renewable energy boom, there are a few ways to invest. The first way would be to buy stock in companies involved in renewable energy generation. But this exposes investors to certain risks, particularly the risk of investing in individual companies. There are times when a company can amount to a poor investment, even with a solid fundamental backdrop of a booming industry.

As a result, a better way to gain exposure to renewable energy could be to buy exchange-traded funds, or ETFs.

Renewable ETFs: the good, the bad, and the ugly

The rise in socially-responsible investing has given birth to a new niche product in exchange-traded funds. These are called Environmental, Social, and Governance funds, or ESGs. State Street Corp. (NYSE:STT) which offers the flagship SPDR brand of ETFs, is a pioneer in ESG funds. State Street’s ESG offerings include the SPDR MSCI ACWI Low Carbon Target ETF (NYSEARCA:LOWC). On the plus side, the fund has a very low annual expense ratio of just 0.3 percent. However, after a closer review of the fund’s holdings, some investors may be disappointed.

In the fund’s prospectus, its stated investment objective is to provide investment returns that mimic the returns of the MSCI ACWI Low Carbon Target Index, which is an index that tracks securities of publicly-traded firms with minimal carbon exposure. To formulate a firmer definition of what qualifies as ‘low carbon’, the index addresses two categories of carbon exposure—carbon emissions and fossil fuel reserves. The Low Carbon Target ETF takes an overweight position in firms deemed to have low carbon emissions relative to sales as well as those with low potential carbon emissions based on per dollar of market capitalization.

However, analyzing the fund’s holdings reveals a concerning lack of investments in the renewable industry. The fund’s top 10 holdings include several blue-chip stocks, similar to what one would find in a typical S&P 500 ETF. The holdings are somewhat disappointing in this regard, and also because many of the holdings do not exactly have a low carbon footprint—there are several stocks from Big Pharma and Big Tobacco included in the fund, and the fund even holds stocks that service the oil and gas industry like Schlumberger (NYSE:SLB) and Kinder Morgan (NYSE:KMI).

Similarly, State Street’s SPDR S&P 500 Fossil Fuel Free ETF (NYSEARCA:SPYX) leaves a lot to be desired. While the fund technically does not own oil companies directly, it owns shares of several companies in the industrial sector which supply the oil and gas industry or have large fossil fuel businesses outright. For example, the fourth largest holding of the fund is General Electric (NYSE:GE). While GE is a household name that most Americans likely associate with appliances, light bulbs, and locomotives, it also has a huge oil and gas business. In fact, GE derived $16.4 billion of revenue from its oil and gas segment last year, which made it the company’s fourth largest operating unit by sales.

Investors will find much of the same from the iShares MSCI ACWI Low Carbon Target ETF (NYSEARCA:CRBN), sponsored by BlackRock (NYSE:BLK). The Low Carbon Target ETF is arguably an even worse offender, since it actually owns shares of fossil fuel companies. For example, in addition to GE, the fund held more than $1.1 million worth of Exxon Mobil (NYSE:XOM) stock as of June 9. This is not a one-off; among the fund’s exposure breakdown, the fund allocates 11 percent of its holdings to the industrials sector, and another 6 percent to the energy sector.

Curiously, it’s virtually impossible to find any investments in wind, solar, or renewable energy firms to speak of within these low-carbon ETFs. For an investor wanting to gain exposure to low fossil fuel or environmentally conscious industries, these types of firms seem to be a natural solution. Consequently, whether an investor will be happy with this fund depends on their definition of low carbon.

The bottom line

Exchange-traded funds have a number of relative advantages versus buying individual stocks. Primarily, ETFs allow investors to hold a basket of securities, which helps diversify a portfolio and guard against poor performance from any individual holding.

However, not all renewable energy ETFs are created equal. Some bill themselves as carbon-free, but could hold some fossil fuel companies. As a result, the financial industry has a lot of work to do when it comes to fossil fuel free or low carbon ETFs. With that in mind, it is imperative for investors to thoroughly review a fund’s prospectus to ensure you are getting what you want out of your investments.

Companies to watch

While renewable energy or low-carbon ETFs are generally disappointing, there are more suitable alternatives for investors. Rather than seek out ‘low carbon’ or ‘fossil-fuel free’ ETFs, investors may be better served investing in specific industry-focused ETFs. For example, two good options for investing in solar power are the Guggenheim Solar ETF (NYSEARCA:TAN) and the Market Vectors Solar Energy ETF (NYSEARCA:KWT). Admittedly, these ETFs have not performed well—TAN and KWT are down 34 percent and 29 percent, respectively, year-to-date. This is due to falling stock prices in the solar power industry, as investors become more pessimistic. But should the industry successfully turn itself around, the dips could be good buying opportunities.

Other promising areas include wind energy ETFs such as the First Trust ISE Global Wind Energy Index Fund (NYSEARCA:FAN). This fund is up 5 percent so far in 2016, and it invests predominantly in wind energy companies. 

Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance. 

Originally published on June 15, 2016