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PowerShares Cleantech ETF (NYSEARCA:PZD) launched on October 24, 2006, and quickly produced above-market returns. The fund gained nearly 42% in 2007, fueled by increasing concerns about environmental issues and a strong demand for alternative energies—solar energy in particular. The fund’s rapid buildup in momentum led to its purchase by the PowerShares Momentum Tracker portfolio on June 27, making it the longest-held fund in the portfolio as of last week. The fund’s momentum declined during the last two months, however, causing it to retreat to 18th on the Power Shares Momentum Table, where it ranked for the last three weeks.

PZD’s rally persevered even after the subprime mortgage mess caused the market to falter last fall. But the fund lost steam after reaching an all-time high on December 26. PZD fell more than 13% year to date through March 27, underperforming the S&P 500 by three percentage points. After a rookie year that delivered one of the best performances among ETFs, PZD is suddenly demonstrating that its unique take on environmentally sound stocks isn’t unshakable.

Despite its recent pullback, PZD still compares favorably with broad-market indices and most sectors over the breadth of its short history, and there are plenty of compelling reasons to believe that the cleantech industry is ripe with growth opportunities. The last few years have seen explosive profit growth at numerous environmentally oriented firms—and it seems clear that the need to address environmental concerns will only grow in the years to come. If consumers, governments and businesses continue to favor buying “green”—even in a weak economy—PZD may prove that cleantech is more than a passing trend.

Cleantech stocks are not identical to “clean energy,” “green,” “socially responsible” or “envirotech” stocks, although they do overlap with the stocks in those categories. Many environmentally oriented funds invest in businesses poised to benefit from regulatory developments, or they screen out firms that have spotty environmental records. A cleantech approach, on the other hand, prioritizes firms that are proactively pursuing innovative and effective solutions to environmental problems. Rafael Coven, the founder of the index PZD tracks, describes the fund’s philosophy this way: “A cleantech strategy focuses on positive screens—selecting the companies that will provide us with the clean technology solutions that deliver major advances in energy supply, resource efficiency, agriculture, etc. And, of course, profit handsomely in the process.”

The fund’s distinct approach could have considerable implications for the way it invests. While many “green” funds scrambled to snare a piece of the booming market in grain-based ethanol fuels in recent years, Coven’s Cleantech Index steered clear. Coven explained the reason in a recent interview with the newsletter Corporate Knights: “Any grain-based ethanol company is an environmentally harmful, tax-financed boondoggle that wastes precious resources and drives up food prices for the poor.” Likewise, investors shouldn’t expect to see stocks of firms engaged in developing “clean coal” technologies in PZD’s portfolio. Avoiding those industries appears to have worked in the fund’s favor over the last year. The index also turns a cold shoulder to stocks in firms that appear to be simply rebranding themselves as “green” and shies away from firms that derive only a small percentage of their revenues from the cleantech component of their business.

The firms that are represented in the Cleantech Index and in PZD’s portfolio hail from a wide range of sectors and industries, with energy-related stocks taking up the largest chunk of PZD’s assets. (The fund’s energy allocation recently accounted for 41% of assets.) The remainder of the fund’s portfolio largely consists of stocks in the industrials (15%), materials (13%) and water resources (10%) sectors.

PZD typically doesn’t weight single stocks heavily—none of its holdings recently composed more than 3.6% of total assets. And most of those stocks are small: The fund’s portfolio recently had an average market capitalization of just $2.9 billion and held nearly 10% of assets in microcap stocks. Some larger firms do make the cut, however. For example, recent number four holding Siemens (SI) is a $95 billion German industrial firm that qualifies as cleantech in part because of its fuel cell business. The stock has been a major drag on PZD lately, falling nearly 30% year to date through March 28.

Solar energy shined brightly in 2007, accounting for much of PZD’s strength. Recent top holding First Solar was the best solar performer in the fund’s portfolio, which holds about 14% of assets in shares of solar firms. The entire solar energy industry has thrived in recent years, helped along by generous subsidies doled out by governments throughout the world. It’s uncertain whether many solar firms will be able to survive on their own when those subsidies fade away, as is likely to happen at some point. But First Solar is far ahead of its competitors in terms of the cost-effectiveness of its manufacturing process and the global breadth of its customer base. Morningstar speculates that First Solar is one of the only solar firms that could turn a profit in an unsubsidized environment. Shares in the firm gained an amazing, looks-like-a-typo, 794% in 2007 but have fallen about 13% year to date through March 30.

Coven, though optimistic about solar energy in 2008, allows that solar stocks were driven up in 2007 at least in part by a degree of “irrational exuberance” on the part of investors. Whether that applies to the cleantech sector as a whole is uncertain. But there’s no doubt that the kinds of small-growth stocks that this fund favors can fall into obscurity just as quickly as they can burst to the head of their industry—so investors here would be wise to keep any stake modest.

Source: PZD: Cleantech Loses Steam After a Stellar 2007