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Wind power is widely seen as the alternative energy source that's closest to prime time. Wind can compete head-to-head on a cost basis, without subsidies, with most other kinds of electrical generating power.

First Trust launched the first wind-power ETF in the U.S. on June 17, with the First Trust ISE Global Wind Energy Fund (ticker: FAN). Robert Carey, chief investment officer for First Trust, spoke with the editors of HardAssetsInvestor.com about how the new fund works and where it might fit in an investor's portfolio.

HardAssetsInvestor.com (HAI): What gave you the idea to launch a wind ETF?

Robert Carey, chief investment officer, First Trust [Carey]: We've actually been looking at a whole variety of alternative energy ideas for quite some time, including the wind space. It is a big focus of ours and an area in which we are making a big investment going forward.

HAI: How does the underlying index work?

Carey: The index is pretty straightforward: Two-thirds of the index is invested solely in "pure plays." There are companies where wind is their main business, whether they operate a wind farm or are involved in equipment, infrastructure, technology or transmitting energy [from a wind farm to a power grid]. Wind is the primary focus of these companies' business.

The other one-third of the index consists of companies that are in involved in wind in some form, but not as the only thing they do. General Electric is the classic example, but you can look at a company like BP and see that it is involved in wind as well.

These conglomerates play an important role in the industry, but if we had done a traditional market-cap weighting of all the companies in the space, the index would have been dominated by big energy companies and big oil companies that don't have wind as their main focus. The two-thirds/one-third approach creates a balance between the two.

HAI: How has the index performed on a historical basis?

Carey: The index was created in late 2005, and it has gone up quite significantly since then. For the past one year ending in May, the index was only up 9%. But it was up 89% in 2006, and 67%-68% in 2007. It's definitely an area of the market that has been running forward a lot faster than the market as a whole.

HAI: That could give some investors pause, as they worry if the stocks are getting ahead of themselves. Do the fundamentals support such an aggressive run-up?

Carey: There's no question that, when you look at the industry, it's growing very, very fast. Installed wind capacity has gone from nothing 10 years ago to around 1% of the installed capacity of the electric grid today. That's remarkable, given the sizes we're talking about. But still, it's only 1% of capacity - there is lots of room to grow.

When I take a look at all the opportunities that these companies have, and what the analysts say about how capacity will continue to grow by 30% per year over the next few years, the growth rates are attractive. You have very high fossil fuel prices that make the economics of wind power more competitive, and technology and materials that are making wind power more efficient and effective. Add to that the fact that you have public policy advancing this market as well, and you can see why people are positive on this space.

We computed the price-to-earnings ratio of the index, and it's currently around 25. To be honest, I would have thought it would be higher than that, given the way the stocks have performed recently. But the market as a whole is selling for about 15X estimated earnings, so investors should weigh the fact that this is a growth-driven index.

The bigger companies in the index - companies like REpower, Vestas and others - are very profitable. Their margins and return on capital are all going up significantly, so it makes sense that the stocks would be going up. Return on capital has one of the highest correlations with stock returns of any metric.

Normally, with an industry like this, you might think it would be unprofitable, but it's not - at least not for many of the companies involved.

HAI: How would an investor use this fund in a portfolio?

Carey: You have to look at it as a satellite investment. Within the energy component of a portfolio, this would fit nicely on the energy side of things, a way to tilt that portfolio towards wind power and clean energy.

The energy sector is a much bigger part of the S&P 500 today than it was in the past, so allocations to that area are growing. If the sector continues to advance, this ETF offers a way to get a potentially higher return from the energy part of your portfolio.

HAI: Anything else about the index that we should have asked?

Carey: The one nice thing about buying wind in an ETF is that it really is a basket of stocks that are not easy for investors to buy on their own. It's one thing to have a Schwab account and buy a lot of companies, but if you look at the top 8 or 9 or 10 stocks in the index, these are stocks that don't have a lot of coverage in the U.S. market right now. It's hard to find analyst quotes or even basic company information.

Given the narrow scope of the industry, it's nice to be able to get exposure to this one sector and not bear a lot of company-specific risk.

If you look at these companies, they are not widely followed at this point - like Vestas and REpower. One is headquartered in Denmark. It's hard to find people who are experts in that industry, but if you look at the fundamentals, it has a solid perspective. The trick is to avoid the single-stock exposure.

Source: Wind Power Is Blowing Strong Right Now