Alternative Energy

GLOBAL OUTLOOK
Looking at the market globally, the outlook is positive. The US is the global leader in an industry whose growth rate is between 20% and 30% and where the competition is intense for assets. The ongoing takeover speculation has moved share prices higher this year. Although there are new entrants in the market, especially from Asian countries, critical mass is necessary for companies that want to play a role in this market. Dynamic companies must have not only the technology, but also a strong balance sheet and the ability to raise money. It is a competitive market where technology is being developed at blinding speed. Each day you can read about a new type of solar cell or a new technology that can produce electricity from waves along the coast.

There is a bet on the industry that is not exactly technological: the US Presidential elections next year. Should the Democrats win this time around, they would very likely push for broad energy packages in favor of a vast expansion of renewable energy sources. The scenario is plausible. Taking benefits given to the oil industry today, it is possible they would launch a series of initiatives to develop solar power, wind power, and so forth.

Political intervention and incentives of varied kinds would influence the industry, depending on the outcome of the elections. Recently, Illinois Sen. and Democratic Presidential hopeful Barack Obama proposed investing $150 billion over the next 10 years to develop and produce climate-friendly energy supplies. His main opponent in the race for the nomination, New York Sen. Hillary Clinton, proposed a $50 billion strategic energy fund to boost research in alternative technologies, using money raised by imposing fees on oil company profits.

The market performance of financial products that invest in renewable-energy companies shows how this industry is positively correlated with oil prices. This can easily be explained. As oil prices go up it becomes more convenient to invest in alternative sources of energy. Should oil prices remain high, the future of the industry would be bright and investments would continue to grow to make renewable energy more competitive.

Growing global oil demand is supposed to continue in the next decade due to the economic growth of Asian countries such as India and China. There is a historic and structural shift in the global pattern of growth toward these countries, and this is not going to end anytime soon. The supply of energy is to adjust to the increasing demand. The oil industry will react to increasing demand with new investments to increase their output. This could reduce oil price, although many already make assumptions about the availability of oil reserves in the world.

In this context, developed countries and especially the US face an energy supply crisis in the coming decades and become ever more dependent on imported supplies with a profound impact on their foreign and military policies. The reliance on renewable sources of energy to gradually reduce (or slow the growth in consumption of) petroleum use is a politically sound option. For example, the European Union recently enacted a target of deriving 20% of its total energy needs from alternative sources by 2020. This represents a threefold increase from current levels. Such initiatives have a significant impact on the world's energy consumption patterns and display how alternative energy is at the center of structural changes.

INVESTING IN ALTERNATIVE ENERGY
How long it will take for renewable energy to become competitive and how this industry can develop newer and cheaper technologies remain to be seen. But the process of increasing the alternative energy share is ongoing, and it may be difficult to reverse.

This industry presents characteristics that make it attractive to investors with an appetite for risk. In the medium term, returns are promising. There are some basic questions, however, that the average investor may ask. How do you approach this market? How do you choose the right companies? How do you reduce risk? Initially, there will be many new companies entering the market, but following the initial euphoria, only the strongest survive and a process of selection and consolidation begins. Investors can be badly hurt if they find themselves on the wrong side.

EXCHANGE TRADED FUNDS
An interesting way to participate in the exciting evolution of the alternative energy industry is through exchange traded funds (ETFs). They are baskets of securities traded on an exchange. They help the investor focus on an asset class. All the major stock indexes have ETFs based on them. There are ETFs for US companies, real estate investment trusts, international stocks, bonds, and so forth. Many asset classes publicly available are represented by ETFs. They can be bought and sold at any time during the day. Investors can do anything with an ETF that they can with a normal stock and, as with stocks, you pay a commission to buy and sell ETF shares.

The annual expenses that ETFs charge are normally lower than index mutual funds. Further, ETFs bundle together securities that are part of an index. They allow diversification and sector-specific investments. Low commissions and the possibility to reduce risk through diversification are the main advantages of these instruments. ETFs are an excellent way for an individual investor to enter the marketplace. During the past years they have become very popular, and each month, new ETFs are listed.

In Europe, the first alternative energy ETF is the iShares S&P Global Clean Energy (INRG). It was launched on July 8, 2007, picking up on an investment theme that has been very popular in the US for several years. The fund invests in 30 of the world's largest publicly traded clean energy companies. It is listed at the London Stock Exchange (LSE). In particular, the S&P Global Clean Energy Index was established recently and tracks companies that operate in biofuel and biomass, ethanol and fuel alcohol, fuel cells, geothermal, hydro electricity production, solar and wind production, and technology. Of the companies, 35% are involved in clean energy production such as solar, wind, and bio-based; 65% are involved in the manufacture of equipment and technology.

In the US, there are more choices. The Market Vectors Global Alternative Energy ETF (GEX) was launched on May 9, 2007, on the New York Stock Exchange. The fund tracks the Ardour Global Index (Extra Liquid), which is made up of stocks in 30 companies that operate in alternative energy production. The AGI is a benchmark composite of 88 alternative energy companies from the US, Europe, and Asia, including China.

The Ardour Global Index - Extra Liquid Series (AGIXL) is a subset of the AGI, representing the 30 companies with the highest-average daily trading volume and largest float-adjusted market capitalization. It is rules based and currently screens more than 250 possible candidates for inclusion on a six-month basis. Companies must derive more than 50% of their revenues from alternative energy to qualify. The New York Mercantile Exchange is planning to list a futures contract on the index -- a NYMEX miNY contract -- on the CME Globex electronic trading platform. In addition, they plan to list options on the futures contract.

PowerShares has introduced three ETFs that invest in the alternative energy industry. The first ETF is PowerShares WilderHill Clean Energy (PBW), which was introduced in March 2005 and is traded at the AMEX. The fund normally invests at least 80% of its assets in stocks of companies engaged in the business of the advancement of cleaner energy and conservation. It normally invests at least 90% of its total assets in stocks that make up the Clean Energy Index (ECO).

The ECO is composed of approximately 42 companies that are publicly traded in the United States. Most of them have a market capitalization greater than $200 million. The list of component stocks is reviewed at least quarterly. Companies making up the Clean Energy Index focus on technologies for utilization of renewable sources of energy. The Chicago Climate Futures Exchange lists a futures contract on the index (ECO-Index), which can also be used to hedge against fluctuations in the PBW.

The second ETF is the PowerShares Progressive Energy Portfolio (PUW), which is based on the WilderHill Progressive Energy Index (WHPRO), made up of companies that improve near-term use of fossil fuel resources. These companies progressively reduce pollution from the fossil fuels such as coal, oil, and natural gas through innovative technologies.

Unlike the ECO Index designed specifically for nonfossil fuel sources such as solar or wind power, this index is designed to track transitional technologies for reducing pollution from the traditional energy sources. PUW started trading in October 2006. The fund normally invests at least 80% of its assets in stocks of companies engaged in the progressive energy business. The fund normally invests at least 90% of its assets in stocks that make up the Progressive Energy Index, which is composed of about 47 companies traded in the United States. The list of component stocks is reviewed at least quarterly.

The third energy-related ETF is the PowerShares Cleantech Portfolio (PZD), which was launched in October 2006 and tracks the Cleantech Index (CTIUS). The fund normally invests at least 90% of its assets in stocks that make up the CleantechTM Index. The CleantechTM Index is currently made up of 47 companies that are leaders in "clean technology" innovation and commercial deployment. They operate in the alternative energy industry, water resources, and purification, air quality, advanced materials, ecofriendly agriculture/nutrition, power transmission, and logistics.

Finally, the PowerShares Global Clean Energy Portfolio (PBD) seeks to track the performance of the WilderHill New Energy Global Innovation Index (NEX). The index was launched in June 2007 to track companies working in clean energy worldwide. More than half the companies in NEX are generally listed in Europe, Asia, the Americas, and elsewhere. The fund normally invests at least 90% of its assets in stocks that make up the New Energy Global Index and ADRs based on the stocks in the New Energy Global Index. The fund normally invests at least 80% of its assets in securities of companies that focus on generation and use of cleaner energy relative to traditional fossil fuel use and renewable energy.

The New Energy Global Index is mainly composed of companies in wind, solar, biofuels, hydro, wave and tidal, geothermal, and other relevant renewable energy industry. It includes companies engaged in energy conversion, storage, conservation, efficiency, materials, pollution control, emerging hydrogen, and fuel cells. As of March 31, 2007, the New Energy Global Index consisted of 84 companies.

There is another interesting ETF, the First Trust NASDAQ Clean Edge, which started trading in February 2007. It tracks an equity index called the NASDAQ Clean Edge US Liquid Series Index (CELS). The index, which began in November 2006, is a modified market capitalization-weighted index designed to track the performance of companies engaged in manufacture, development, distribution and/or installation of clean energy technologies, including solar photovoltaics, biofuels, and advanced batteries. The index is reconstituted twice a year in March and September and rebalanced quarterly. The ETF (QCLN) is listed on NASDAQ. The fund normally invests at least 90% of its total assets in stocks that make up the index.

As you can see, ETFs offer different possibilities to individual investors to approach the alternative energy industry, which allow low commissions and diversification. Most of the alternative energy ETFs have been introduced recently. Be mindful that the volume of these products is still low. As liquidity is low, the spreads could be large when buying and selling. Only PBW, which was introduced in 2005, has good liquidity.

FIGURE 1: PERFORMANCE CHART FEBRUARY TO OCTOBER 2007. Since last February, the traditional energy sector represented by the AMEX Select Sector SPDR Fund (XLE) has outperformed other alternative energy ETFs.

One other aspect to take into account is the correlation with other traditional energy assets. As you can see in Figure 1, the correlation between alternative energy and the traditional energy sector is quite high. Since February 2007, most of the ETFs have performed very similarly to the AMEX Select Sector SPDR Fund (XLE). Since last June, alternative energy has outperformed traditional energy (see Figure 2). This strict relationship must be taken into account when considering an investment. My view is that this correlation will remain for a while for obvious reasons. But the relative performance should favor the alternative energy industry because of public attention to political, climate, and environmental issues that will likely lead in the future to government investment policies in the sector.

FIGURE 2: PERFORMANCE CHART JUNE TO OCTOBER 2007. During the past three months, alternative energy ETFs have done well compared to the traditional energy sector (XLE).

Paolo Pezzutti lives in Rome, Italy. He may be reached via email at pezzutti.paolo@tiscali.it.

- Market Vectors Global Alternative Energy ETF (GEX)
- PowerShares WilderHill Clean Energy (PBW)
- PowerShares Progressive Energy Portfolio (PUW)
- PowerShares Global Clean Energy Portfolio (PBD)
- FirstTrust NASDAQ Clean Edge ETF (QCLN)