Alternative Energy

Alternative energy is still emerging as a business and it is not yet clear which companies have optimal solutions for the future. This makes alternative the energy sector ideal for ETFs, which are good at spreading risk among various companies and various technologies. Since PowerShares introduced the WilderHill Clean Energy Portfolio ETF (AMEX:PBW) in early 2005, many new ETFs have come to market. In addition to ETFs that seek to represent the alternative energy sector as a whole, there are funds focused on alternative energy sub-sectors such as wind energy, solar power and nuclear power. There are also several newer products based on related alternative energy memes such as environmental services and global warming. The table below lists ETFs in the alternative energy sector by focus:

Historically the broad popularity of alternative energy solutions and the market performance of the companies pursuing these technologies has increased when energy from fossil fuels such as oil and coal have been expensive or infeasible. All these funds have emerged in the last few years amidst a number of political, economic and environment factors favorable for alternative energy solutions: 1. higher crude oil 2. higher energy prices in all categories 3. increasing in public awareness of long-term political and economic ramifications of dependence on energy from foreign sources 4. increasing public concern about the environmental dangers presented by burning fossil fuels.

Given that the alternative energy sector still depends on government subsidy to make most of these technologies economically feasible, investors should investigate the possible fate of these technologies should government support falter. The supply and demand of for alternative energy fuels can be volatile, and with it the companies that develop and install the technology and in tuirn the ETFs that hold these companies.

But in a larger sense alternative and renewable energy is becoming increasingly important, and faster than many people realize. Europe in particular has long turned to alternatives to fossil fuels: France provides about 80% of its electricity from nuclear power, Denmark originates 20% of its power needs from wind, in Germany, over 6% of total usage comes from wind. The U.S., by far the world's largest energy consumer, by contrast gets less than 2% of its power from wind.

Because of the newness of the sector we do not see these ETFs as core holdings but we do believe that exposure to alternative energy companies belongs in any well-balanced portfolio. Choosing a fund will depend on an investor's risk profile and focus. Probably the most significant factors to consider are diversification and foreign holdings. Though all funds hold foreign assets, the global funds are especially attractive in this regard as they tend to have 30% or fewer domestic holdings. Both global alternative energy ETFs are well-established with capitalizations of several hundred million dollars. Top 10 holdings in GEX comprise around 60% of the fund as compared to the 20% or so in PBD. Greater diversity tampers volatility but can also drag down returns.

Diversity of holdings is also an important consideration for investors in broadly-focused primarily domestic alternative energy ETFs. Of the generally focused funds PBW and PZD tend to be the most diversified, with top-10 holdings representing around 20% of the total fund, as compared to around 50% for the top 10 in QCLN and PUW. In a sub-sector like wind or solar concentrations are less apparent because of the dearth of names overall. The primary advantage, as stated above, is that investors will benefit from the diversity that an ETF provides in comparison to owning a single company name. Both solar funds: First Trust's Van Eck's KWT and Claymore's TAN have top 10 holdings representing about 60% of the overall fund. Expect similar returns. Of the two nuclear funds PKN is more diversified. Its top 10 assets representing about 30-35% as opposed to close to double that with NLR.

There are a few ETFs included here though they are somewhat different in focus from the alternative and renewable energy ETFs discussed above: Van Eck's EVX, which holds waste storage and removal companies, Elements GWO, which holds companies with products and services focused on minimizing global warming, and Claymore's GRN, which holds eco-friendly firms. Though we applaud the socially responsible missions of GWO and GRN, because of their low volume and relatively high expense ratios given their holdings, and in the case of GWO, counter party risk, we don't recommend these funds at this time.