Wanted: An Alternative Energy ETF That Plays by Its Own Rules (PBW)

Includes: IGE, IXC, IYE, PBW, VDE, XLE
by: Richard Kang

There are alot of energy based ETFs out there to select from, many of them covered well on Seeking Alpha's ETF site. We have been holding all our energy related positions despite them being down roughly 12% from their peak in early May. Relatively high cash balances and some broad market put options have helped ease the pain. We still feel strongly about our long-term view on the commodity complex, especially energy, as well as certain other areas like emerging markets.

For those that have built some cash, this is a follow up to my previous “shopping list” discussion but with a greater focus on energy. Now that we’re well into June, there will certainly be increasing talk of upcoming tropical storms and speculation of their potential growth to hurricane status. With ongoing events in Iraq and Iran, volatility in this area will certainly remain high which should be good for the numerous energy related funds I see popping up.

Below is a 1-year chart for five fairly broad energy related funds, although IGE tracks a broader natural resources index. I include it because according to the iShares website, it has a roughly 78% weight in oil/oil services plus 4% in gas. Not an insignificant divergence among these energy ETF choices, especially during the volatile period of the past three months.

Energy ETF 1-yr chart:

Energy ETF # 1

What interests me and what has been a great performer in our portfolios has been alternative energy, specifically the PowerShares WilderHill Clean Energy ETF (NYSEARCA:PBW). Taking the two “middle of the group” performers from the above chart and including PBW, we have the following 1-year chart:

PBW 1-yr chart:

Energy ETF # 2

I note two things from this second chart:

1. There is a fairly high correlation between all the funds which is of little surprise.

2. PBW's relative outperformance of other broad energy ETFs.

With regard to the correlation, we can see from this chart that from early June 2005 to early January 2006, the lines overlap fairly well. The only sizeable divergence was during late August/early September (prime hurricane season).

But what about the sizeable divergence for most of 2006? The stocks shown above have similar up and down blips, but PBW seems to have become a “high beta” version of the energy plays. Proof is in the recent declines. PBW is down nearly 18% since its peak on May 9th. VDE and XLE’s declines are 13% and 12% respectively.

This really isn’t that surprising if you go to the PowerShares website and look at the holdings of PBW. The roughly 40 positions are certainly not all big names. Big sector weights in info tech (30%) and industrials (35%). Energy is shown as having only a 2.4% weighting. Average market cap of PBW is somewhere between that of PowerShares' small and mid-cap ETFs. So the volatility is not that surprising.

Analysis of the 4 largest holdings (IMCO, QTWW, MGPI, ZOLT) as well as the largest positions thereafter show a general common uptrend from the beginning of the year. All of these positions have a story that is quite separate from the broad energy story. Thus, it might seem that during times of higher energy focus in the financial markets (like hurricane season), PBW behaves more like an energy fund as investors play the alternative angle. At other times, the fundamentals of its underlying holdings play a more distinctive and significant role.

If this hurricane season is anything even close to last year, you really have to wonder if alternative energy will be perceived as a place for significant asset allocation. I’m still not sold on alternative energy’s potential to replace traditional energy to keep the manufacturing process moving. I just can’t imagine how alternative energy could even come close to addressing global energy needs all if oil, coal and nuclear were suddenly wiped off the planet today. We’ve got a long way to go which is all the more reason to see the potential upside on something like PBW.

Finally, I was recently at an environmental finance conference sponsored by the University of Toronto. The main subject of the conference was actually “cleantech.” Interesting that there was a big absence of investors (institutional or retail) at the event. Through a contact from the event, I learned of a potential cleantech ETF. This was confirmed Wednesday of last week with the new of PowerShares’ SEC filing of 31 (wow!) new ETFs including the PowerShares Cleantech Portfolio ETF. Something to watch for.

Again, what we’re looking for here is something that can behave like an energy play during energy sensitive periods (with price action on the upside) and with potential greater upside during times of less dramatic energy sensitivity in the markets and general public persona.

Just remember that PBW is volatile. The current 18% drop is not the first time this has happened in PBW’s short 15 and a half month life. It had about the exact same percentage drop in its first two months (March/April 2005) and again in the fall of 2005 (basically after Katrina). Strong stomach required.

PBW 1-yr chart:

PBW 1-yr