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Is the Sun Shining for Solar ETFs?

|Includes: KWT, Guggenheim Solar ETF (TAN)

There are a number of reasons to consider investing in alternative energy. First, while oil prices are down from the $150 a barrel we saw last year, they are still high in historic terms. That makes alternative energy a more attractive proposition. Second, greenhouse gas emissions from fossil fuels has become a major concern, and it's likely that emissions will be regulated. Finally, there is concern that even if you disregard the high price of fossil fuels and greenhouse gases, some analysts are concerned that traditional sources of energy can't keep up.

Solar is one of the alternative energy sources with a lot of potential. According to some estimates, the Earth receives enough energy from the sun on a daily basis to provide for the energy needs of every single person on the planet for 27 years. So we know the potential is there.

However, the problem is that for all its potential, there are big hurdles that need to be overcome. For example, one analyst covering the solar industry expects to see a continuing price war. One result of the surge in oil prices was tremendous growth of manufacturing capacity for alternative energy sources, including solar. A lot of factories came online, just in time to flood the market when the world's economy headed down. The result is a price war. Average selling prices for solar equipment have dropped to $1.80 a watt this year from $4.05 a watt in the third quarter of 2008. By the end of 2010, those prices could drop below $1 a watt and by 2011, the figure could be as low as $0.50 a watt.

Many solar companies are not expected to survive this price war. According to one analyst, as many as half of all solar companies will not survive through 2010. The problem is a tremendous amount of overcapacity and a huge inventory buildup. Factory utilization for solar companies dropped to 28 percent from 48 percent last year, and inventories climbed to 122 days of sales, up from 71 days last year.

But there is some bright news for the solar sector. For the first time in a year, signs of increasing demand are appearing. Germany, which is the world's largest solar market, is showing definite signs of recovery. Other countries like France, Italy, and the United States are showing improvement, and Japan is likely to increase solar subsidies as the new government puts its stamp on the country's economy.

There are tremendous problems for investors looking to put their money to work in solar stocks. With approximately half of the companies in the field at risk of going bust, how can investors figure out which stocks to choose? After all, how many companies can survive a price cut in their product to one eighth their prior level in just three years?

One answer for investors is to not attempt to choose individual stocks. Instead, investors should consider ETFs. There are two solar focused ETFs which track the MAC Global Solar Index. Both of them charge investors a 0.65 management fee, which is on par with ETFs as a whole and lower than most mutual funds.

The methodology of these two ETFs is similar. Both of them identify all of the companies in the solar field, and then assign them a value of 1, 0.5, or zero depending on the percentage of revenues obtained from solar energy. That score is then multiplied by the company's market capital to determine that holding's weight in the index. This process is repeated quarterly so that the holdings of the ETF reflect the company's contribution to the global solar market.

The two ETFs are the Claymore MAC Global Solar Energy ETF and the Market Vectors Solar Energy ETF. Clicking on either link will take you to Morningstar, where you can read their report on the ETF.

Investors who put their money into these ETFs should be prepared for volatility, as the solar market is an emerging one. Focused funds such as this one should only be a small portion of your overall portfolio. But if you're looking to gain exposure in an industry with a bright future, this is one way to play it.

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