Solar farm on a rural hillside

Clean energy stocks had electrifying gains in 2020, as did the funds that hold them. Unfortunately, the three Canadian-listed clean energy ETFs missed out on a triple-digit year, launching just as the market became more challenging.

The Harvest Clean Energy ETF and the BMO Clean Energy Index ETF both launched in January, followed closely by the February debut of the First Trust NASDAQ Clean Edge Green Energy ETF. All three have been jolted by losses of 17% or more since inception as of March 31.

Valuations for clean energy companies had become rich, with estimated forward price-earnings ratios of more than 60 times, said Karl Cheong, head of distribution at Toronto-based FT Portfolios Canada Co., which operates as First Trust Canada. The company’s ETF is a clone of the similarly named US$2.7-billion ETF, managed by an affiliate and listed in the U.S., which returned 184% in calendar 2020 and 42.7% the year before.

Though clean energy stocks were due for a correction, according to Cheong, the recent losses have created a more favourable entry point for investors who have a longer-term holding period.  “We really believe in this space. These companies will grow into those earnings over time,” Cheong said. The outlook for clean energy “is still very strongly positive if you can withstand the volatility.”

Mark Raes, head of products with BMO Global Asset Management Canada, noted that the market has recently seen a rotation away from growth stocks toward more traditional, value companies. “But it certainly doesn’t impact the long-term growth story that’s out there.”

Raes said clean energy can add another growth element to the portfolio, often with a lower correlation to the broader market and thereby enhancing diversification. The BMO ETF is based on the same index employed by the US$5.3-billion iShares Global Clean Energy ETF. The largest of its kind in the U.S., it returned 141.8% in 2020 and 44.4% in 2019.

Paul MacDonald, chief investment officer and portfolio manager with Oakville, Ont.-based Harvest Portfolios Group Inc., said the Harvest ETF is a low-cost way to participate in the growth and development of renewable energy. “So any type of pullback like what we’ve just seen, we see that as opportunity.”

The Harvest ETF charges a management fee of 0.40%, not including expenses. That makes its management expense ratio (MER) slightly higher than that of BMO, which charges 0.35% and will cap its MER at 0.40%. The First Trust ETF’s MER is 0.77%.

There are multiple reasons — economic, environmental, social and political — why proponents of clean energy ETFs see a market that will have long-term secular growth.

“New sources of power and power projects are going to be predominantly in renewable projects,” said MacDonald. In a presentation to advisors, Harvest cited projections by the U.S. Energy Information Administration that renewable energy will be the source of 38% of global power generation by 2025, up from 31% in 2019 and 20% in 2010.

Contributing to the shift toward green energy are favourable political winds. In the U.S., one of the first acts of the newly elected Biden administration was to rejoin the Paris accord on climate change. The president’s US$2-trillion infrastructure plan unveiled last month includes billions for electric vehicle charging stations.

In Canada, the Trudeau government’s carbon tax was upheld as constitutional in a March ruling by the Supreme Court of Canada. Overseas, the European Union is investing heavily in environmental initiatives in support of its goal of net-zero greenhouse gas emissions by 2050.

Both retail and institutional investors, and the business community as a whole, are recognizing the importance of environmental, social and governance (ESG) factors, which favour clean energy over traditional sources. In response to public demand, there has been a proliferation of ETFs with ESG-related themes.

A powerful driving force for clean energy investment is its growing cost-competitiveness. Stocks tied to this theme had been booming even during the administration of U.S. president Donald Trump, whose energy pronouncements included praise for “beautiful clean coal” and tilting against “cancer-causing” windmills.

First Trust’s Cheong said that over the past five or six years, wind and solar power have become cost-competitive with natural gas, and even cheaper as an input relative to coal. “That started driving investments, as people are concerned about not just being environmentally friendly but making a profit.”

Like other thematic strategies, clean energy ETFs are by definition multi-sector in nature. “You’re no longer necessarily constrained by sectors or even industries,” said Raes, whose ETF is global in scope. “And you’re trying to find those companies that are most exposed to whatever thematic approach you’re trying to identify, in this case clean energy.”

According to Morningstar, the BMO ETF recently held 46% of its portfolio in utilities stocks, with the next highest weightings being 31% in technology and 20% in industrials. However, the performance of clean energy companies may be very different from the sectors in which they’re categorized. The BMO ETF’s stock weightings are based on a combination of market capitalization and a clean energy exposure score calculated by Standard & Poor’s personnel.

The Harvest ETF holds the 40 largest clean energy companies that it has identified globally. A hefty 49% are utilities stocks, followed by 32% in technology and 20% in industrials. “When we think of renewable energy and clean energy, we think of the companies that are basically producing energy, predominantly through renewable sources,” said MacDonald. “And the companies that make the equipment that go into that.”

Harvest’s stock picks are equally weighted. MacDonald said this enables the ETF to provide “more exposure to the breadth of the development of the renewable energies over the course of several cycles.”

The First Trust ETF takes a broader approach to defining clean energy companies but it’s restricted to U.S. listings. Its top holding is California-based Tesla Inc., the world’s leading maker of electric cars. According to Morningstar, the First Trust ETF recently held 46% in technology stocks, 19% in industrials, 15% in consumer cyclicals and only 9% in utilities. “Ours is a more green-technology type of ETF,” said Cheong.

Employing modified market-cap weightings, this ETF has a bias toward larger companies. “They’re generally the innovators and leaders in a rapidly growing industry,” Cheong said. But at each quarterly rebalancing of the reference index, the weighting for any one name is capped at 8%.

In some of the model equity portfolios that First Trust has created, there’s close to a 20% weight in thematic investments, which include clean energy. “If you’re looking to reach clients’ retirement goals longer term, you have to be looking at these particular areas in order to have a meaningful impact on increasing your returns,” said Cheong. “We think the earnings are just going to way exceed the overall market.”

For clean energy in particular, a weighting of 2% to 5% “makes lots of sense in a well balanced portfolio,” he added.