Green ETF Model Needs Reworking

Wind turbines spin behind a field of solar cell panels near the headquarters and production facilities of German solar cells producer Q-Cells near Bitterfeld, Germany.
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Wind turbines spin behind a field of solar cell panels near the headquarters and production facilities of German solar cells producer Q-Cells near Bitterfeld, Germany.

While the booming ETF industry has added dozens of greenfunds to its ranks, the future of green investments may mean fewer funds with greater diversity.

“What you'll notice is that almost every available green index or ETF is in a silo, such as solar,” says Garvin Jabusch, chief investment officer of investment firm Green Alpha Advisors, about the ETF landscape, adding that specialization like that may not work down the road.

Jabusch and others say taking a broader cross-industry,-sector and -market capitalization approach makes “green” more of an investment style like growth or value, rather than a defined sector with a myriad of subgroups that little in common.

Green ETF investment themes now break down into two main groups.

Sustainability funds, the most established group of ETFs, focuses on publicly traded companies making some kind of defined progress towards strong corporate sustainability goals, like the iShares USA ESG Select Social Index Fund

The second and more diverse group targets traditional green subsectors, like renewable energy, carbon credits, and water – including cleantech-focused ETFs like thePowerShares Cleantech Portfolioand one of the largest green ETFs by assets, the PowerShares Water Resources with $1.1 billion in net assets.

Online investment advisory MarketRiders has identified 30 green-sector ETFS in a universe of over 1,200 funds. Their combined net assets ($3 billion) is a tiny slice of the $900-billion ETF market.

Both existing groups of green ETFs have their own challenges.

Traditional green subsectors, like solar power and carbon ETFs, often rely on governmental policy in the form of supportive legislation or regulation.

Such support, however, comes and goes for a variety of reasons, including election results, and in both the best and worst of times sometimes undercut by policy uncertainty.

“Recent events have provided reminders, if we needed them, that policy makers and governments in general cannot be counted on to do too much,” says Jabusch.

Rob Wilder, founder and CEO of WilderShares, the index provider for Invesco’s PowerShares WilderHill ETFs adds that 'policy-driven investment ideas always bring a “danger of 'overhype."

“We've seen over-abundant excitement, such as for corn ethanol biofuels,” he says. “But there's also been more valid interest in other areas that, in my own view, warrant it.”

Another shortcoming is that so-called sector ETFs must meet the diversification requirements that typically require a minimum of 20 companies.

But in some areas—wind energy, for example—finding 20 companies can be tough, so the qualifying definition, or criteria, are widened.

Instead, the investment focus should be on future growth—the hundreds of small companies that make some aspect of green, like energy efficiency, say both Wilder and Jabusch.

Meanwhile, sustainability funds and their underlying indices define sustainability in their own terms; They poll management of publicly traded companies about sustainability efforts, and then compare the results to their baseline definition.

For example, the Dow Jones family of sustainable indices—launched in 1999 an managed by Dow Jones and sustainability advisory firm SAM—send voluntary questionnaires out to 2,500 companies and select the top-ten responses from each of 57 identified sectors.

“We are in a favorable position,” says Francois Verti, spokesman for SAM, saying the firms' reputation among investors mean that the questionnaires become “a priority” for management response.

“There is pressure from pension funds managed who want [their funds] invested in a sustainable way,” adds Verti says.

Jabusch calls SAM’s definition of sustainability “pure marketing,” with selection bias inherent in the process that could exclude green innovators at the expense of “greenwashed” corporate titans.

PowerShares’ Wilder says focusing sustainability more on corporate cost-cutting than PR motives could make it more easily measured and provide better discovery of companies that are profitable in an environmentally friendly way.

“Doing ‘more with less’ is an inherently environmental way of thinking, and efficiency can be both a money saver and green,” says Wilder.

“Thousands of small and large companies are working toward sustainability, many of them very profitably and with rapid growth,” adds Jabusch. “These are obviously the ones we try to identify (as investments) for our clients.”