Tuesday, March 22, 2016

New-to-Market: ETHO

New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors.  While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.

When was the last time you thought of the word “innovative” when thinking about America’s once great manufacturing hubs in the rust-belt?  If you said “almost never,” you’re not alone but that image of slow decay is being erased thanks to the presence of strong academic institutions that help foster new growth.  Albany, NY may have become a center for nanotechnology and Buffalo, NY a hub for biomedical research, but America’s “Steel City” of Pittsburgh, PA is staking a claim to be at the forefront of financial innovation thanks to Carnegie Mellon University.  For the latest in our series of “New-to-Market” reviews, we feature the Etho Climate Leadership U.S. ETF (ETHO) from Etho Capital.  Solar power will probably never take off in rainy Pittsburgh, but the latest evolution of socially responsible investing for ETF investors isn’t about building a better solar or utility fund, but about bringing the same spirit of responsible growth from the fringes to the heart of your portfolio.

We know that when you hear terms like climate change and socially responsible investing (SRI), your eyes begin to glaze over but before you look for the exit signs, consider how far both “impact investing” concepts have come before you write ETHO off as just another solar fund.  SRI is hardly a new innovation and despite the fact that for many investors it conjures up images of Bernie Sanders and over-priced asparagus water at Whole Foods, even its most fervent adherents couldn’t have imagined how quickly investors would have warmed to it.  While most of us over the last few years have become obsessed with the Fed and macroeconomics, SRI has grown from a just a handful of early adopters and institutional investors to over $6.5 trillion in assets according to the most recent report from Forum for Sustainable and Responsible Investing!  Putting that into perspective, $6.5 trillion would mean that nearly 18% of the $36 trillion in managed assets tracked by Cerulli Associates are invested in accordance within the principles of SRI, a 13.1% compounded growth rate since 1995!

At some point you may have wondered just what exactly defines SRI and how climate change funds fit within that definition?  The concept of SRI has evolved from a core concept of avoiding certain industries and practices into an expansive umbrella for a broad variety of investment philosophies that focus on using environmental, social and governance (ESG) factors to help develop a sustainable strategy. In fact, the concept of sustainable investing has grown to the point where Morningstar, recognizing just how much money is at stake, has begun making ESG scores available to interested investors.  And while SRI, thanks to eliminating whole sectors like energy and defense stocks, has long been held to have a detrimental impact on portfolio performance, the results seem to favor the granola crunchers with the longest running SRI index, the MSCI KLD 400 Social Index, running neck and neck with the S&P 500 TR Index.  Over the last three years ending February 29th, the index was up 10.68% compared to 10.75% for the S&P and up 10.09% compared to 10.13% for the market over the last five years.

While socially responsible investing has only grown in popularity over the years, ETFs espousing the same philosophy have struggled to find a place in investor portfolios.  The first funds to appear on the scene were largely focused on climate change with the PowerShares WilderHill Clean Energy Portfolio (PBW) being the first to appear in 2005.  At first glance, buying into a climate change fund would seem like a no-brainer because after all, when was the last time you heard a presidential candidate talk about opening new coal fired power plants?  Leaders across the globe have long since decided the costs of switching to renewable energy will be a fraction of the potential economic disaster of further climate change and just since 2010 coal has gone from generating 44% of America’s electricity to around 30% while the contribution from renewable resources has gone from less than 5% to nearly 10% according to a July 2015 report from the U.S. Energy Information Administration.  Yet where some see progress, many see an industry that couldn’t survive without government incentives or mandated use while the increasing affordability of solar panels has driven profit margins to low levels.  All of this hasn’t helped make a strong case for investing in climate change or clean energy funds where it hasn’t been a fantastic experience.

PBW was just the first in a series of clean energy ETFs which share a number of common elements that have limited their use in a portfolio while simultaneously making investors regret ever investing in the space.  PBW along with the iShares Global Clean Energy ETF (ICLN) and a host of solar energy funds are all highly concentrated portfolios that share large cross-holdings in a handful of micro and small-cap names that populate the space, resulting in portfolios with an average market cap just over a $1 billion and a strong international focus leading to lower correlations with domestic equities (but are highly correlated to each other) and higher volatility.  So while potentially useful for macro traders looking to play a “theme,” clean energy funds just by the nature of their construction have only a very limited role in most portfolios and it shows.  By the end of 2015, PBW’s ten-year annualized return was -10.49% compared to a 7.31% gain for the S&P 500 - so no wonder Morningstar still puts “clean energy” funds into their “miscellaneous” category.

ETHO and a handful of other new funds including SPDR S&P 500 Fossil Fuel Free ETF (SPYX) and the iShares MSCI ACWI Low Carbon Target ETF (CRBN) are hoping to change that by using an emphasis on climate change to help bring the principles of SRI to a broader universe of stocks.  ETHO’s focus is on investing in companies who are “carbon leaders,” that is, organizations whose total greenhouse gas emissions from the entirety of their business operations (sourcing through final sales), divided by their market capitalization are at least 50% lower than the average for their industry.  Sorting out carbon footprints sounds like a herculean task which is why the index provider uses third-party source Trucost PLC to help simplify the process.  Using a 50% rule might seem arbitrary, but it helps keep the fund from having too narrow of a focus, say only large banks located next to hydroelectric dams, and helps provide a more balanced portfolio although the fund’s prospectus does point out the risk that the portfolio may have high sector concentrations depending on how their screening process shakes out from any one year to the next.

And how large is their universe of potential stocks from which to choose?  Unlike SPYX or CRBN, ETHO doesn’t have a well-defined reference benchmark so essentially the entirety of the U.S. stock market with a market cap above $100 million is open to them with the exception of several sectors consistent with socially responsible investing including: energy, defense contractors, tobacco and gold and silver miners.  Reconstituted annually each November and before they can implement that 50% rule, they first need to determine industry averages and since averages are “touchy” things, they do it twice.  The first pass will result in companies with larger greenhouse gas emissions dragging the average higher so the index provider will start by reviewing greenhouse emissions for a universe of approximately 5,000 names, calculating the industry averages and then eliminating any company whose carbon impact is more than 10x the average before recalculating again.

Only once that has happened can they screen out a select list based on the carbon footprint to average market cap ratio to find those who meet their 50% rule.  They will also eliminate the companies with the five largest greenhouse gas emissions regardless of industry before reviewing the survivors for known ESG issues and then whittling the list down further through an even more exhaustive review by outside groups of NGOs, academics and other professionals to determine whether any of the companies that made the short list have any outstanding ESG issues that aren’t easily quantified or captured by their process.  While all that may sound expensive, the fund’s expense ratio is .45%, which is above the .2% charged by CRBN and SPYX but remains significantly below that charged by dedicated solar funds such as the Guggenheim Solar ETF (TAN) or PBW.

If you’re thinking that a process that involved should produce a short list of banks and tech names, think again as their prospectus states that somewhere between 400 and 430 names should make the final cut each year with industrial names currently holding down the largest spot in the portfolio compared to financials for CRBN and tech stocks for SPYX.  Once that final list of names for the portfolio is determined, they will use an equally-weighted system to produce a portfolio that should have more of a mid-cap feel compared to broad market index funds.  Currently ETHO’s portfolio runs the gamut from micro-cap stocks where the smallest company in the fund is Fuelcell Energy Inc (FCEL) with a market cap of approximately $165 million and a .1% allocation to those mega-cap names like Apple who is the reigning giant in the line-up although that equally weighted allocation means it only takes up .36%.  In fact, those industrial names along with a domestic focus have helped the fund slightly outperform not only the rest of the mid-cap growth space in 2016 with ETHO up .24% through March 18th compared to a 3.22% loss for the iShares Morningstar Mid-Cap Growth ETF (JKH) but its socially responsible peers with a .45% loss for SPYX and a 1.03% loss for CRBN.

So if socially responsible investing makes you think about the Grateful Dead, Vermont and underperforming solar stocks, it might be time to expand your horizons and consider putting ETHO on your watch list.

Thank you for reading ETF Global Perspectives!

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