Beware of Over-Diversification in Green ETFs
Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Risk and return. The goal is to find great returns with as little risk as possible. Green ETFs sound like a simple and easy way to achieve such goals, but looks can be deceiving. Many ETFs mix low-quality firms along with quality firms. It is important to look at an ETF's holdings to understand the true amount of risk it holds.
A Solar ETF with Hidden Risk
The solar industry is the poster child of green energy. Lately the industry has not been that encouraging. Over-production has driven down prices and profits while changing government regulations decrease demand. Guggenheim Solar (NYSEMKT: TAN) gives wide exposure to the solar industry and ends up placing investors' funds in highly leveraged manufacturers that have a doubtful future. Yingli Green Energy and Canadian Solar are both heavily indebted solar firms in the top 15 holdings.
The ETF has an expense cap of 0.65%. In addition to the debt risk, geopolitics plays an important role. The Chinese government can make or break industries based on how it orders their banks to disperse capital. Chinese manufacturers thrive or die on the whims of Beijing. China makes up 29.69% of holdings and any investor in this ETF needs to be willing to watch the Chinese government closely in order understand the prospects of this fund.
A Risky Diversified Green ETF
PowerShares WilderHill Clean Energy (NYSEMKT: PBW) has some of the same problems of Guggenheim Solar with low-quality solar manufacturers. Yingli Green Energy has a high total debt to equity ratio of 4.39 and is 3.07% of holdings. This fund is more diversified in other sectors. Solazyme is one of their top energy holdings. This company focuses on using biotechnology to help fulfill energy needs and provide products for the beauty industry.
WilderHill's Clean Energy ETF has an expense ratio of 0.70% that is on the higher end of the ETF world. Many green companies are unprofitable or need to use a huge portion of their budgets for R&D purposes. The fund's average P/R ratio of -8.54 and return on equity of -5.43% show the negative aspect of investing in developing technology.
A Diversified ETF to Consider
Market Vectors Global Alternative Energy ETF (NYSEMKT: GEX) is similar to WilderHill Clean Energy with a slightly lower net expense ratio of 0.62%. China is not a huge risk as it only represents 6.4% of holdings. This fund offers more quality diversification and its biggest holdings are profitable firms.
Cree is an LED manufacturer and the biggest holding at 10.17% of assets. LED technology continues to grow and replace less efficient legacy technology. Eaton is a large industrial conglomerate with an important electrical services division. Increasing the efficiency and upgrading old equipment is an important part of energy conservation and an overall green strategy. Eaton is the second biggest holding with 10.07% of holdings.
A Sector-Specific ETF to Consider
Considering nuclear energy to be green is controversial, but I believe its lack of harmful emissions makes it environmentally friendly. Market Vectors Nuclear (NYSEMKT: NLR) invests in various parts of the nuclear supply chain. Supply constraints in the energy sector should ensure strong demand for miners. The net expense ratio of 0.60% is much higher than that of mass market funds, but normal for specialized ETFs.
Holdings are nicely diversified between industrials at 39.2%, energy at 34.0%, utilities at 22.3%, and financials at 4.4%. On US exchanges it is difficult to invest in uranium outside of miners and utilities, but this ETF offers a good amount of exposure into the construction firms. The biggest holding is the Japanese construction firm Mitsubishi. After the Fukushima disaster, the firm faced a big drop in their nuclear order book but already domestic demand has come back. Cameco is a very profitable Canadian uranium miner and it is the second biggest holding.
ETFs offer security through diversification, but it is important that the underlying companies and industries are strong. Market Vectors Nuclear offers positions in strong miners, construction firms, and utilities with high barriers to entry. Market Vectors Global Alternative Energy is exposed to a number of industries, and its main holdings are profitable industrials firms.
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