A Reader Responds: Yes, there is Alternative Beta (and Alpha) in Alternative Energy

26 March 2008

Alternative energy is one of a whole set of new asset classes facing institutional investors.  Like portable alpha and 130/30, it has created a new set of opportunities and risks for both investors and managers.  So what better way is there to explore an emerging market such as “Clean Tech” than to examine its alpha-generating potential?  Thus, last fall we stacked a major alternative energy ETF against an energy ETF.  But to our surprise, we found very little sustained outperformance.

Several of you wrote in to say we were ignoring the social benefits of clean technology (which we were) or that we were trying to evaluate these technologies solely on the basis of cold hard numbers (which we also were).  But one of Canada’s leading clean tech fund managers wrote in to acknowledge our analysis and suggest why there is still alpha potential in alternative energy.  What follows is an interesting, and refreshingly dispassionate, perspective on this issue by Greg Payne, the lead portfolio manager at Investeco Financial, an environment sector fund manager.

Special to AllAboutAlpha.com by: Greg Payne Investeco Financial

In a posting on November 26, 2007 (“Is There Alternative Beta in Alternative Energy”) AllAboutAlpha’s “Alpha Male” states that alternative energy returns over the past year have been both significantly correlated to general energy prices, and highly volatile.  This is true.  But as Alpha Male admits, alternative energy may provide alpha and alternative beta in the future in ways that we have not seen in the past.  For good reason, it will.  This is precisely why active management will yield significant benefits in this sector.  

A History of Alpha in Clean Tech

Over the past 5 years, alpha (vs. the S&P 500) has been available in both traditional energy and “Clean Tech”.  This can be seen by comparing the alpha of the past 5 years for the traditional energy ETF (the Energy Spider XLE) and a Clean Tech index (CTIUS) against the S&P 500.

So if both sectors produce alpha, and traditional energy has uncovered more alpha in the past than Clean Tech, why bother investing in Clean Tech now?

Past Performance is no indication of future returns

Alpha in both traditional energy and clean tech has historically been driven by (i) oil prices and (ii) environmental regulation.  The higher alpha from traditional energy over the past five years has likely been the result of high oil prices.  However, going forward, environmental regulation will likely become a more important driver of returns. 

That said, there is an inefficient distribution of information about each of these drivers and their effect on the emerging Clean Tech sector (and the individual companies within it).  Accordingly, certain market risks and opportunities associated with these drivers have not yet been accurately priced, and therefore Clean Tech is rife with opportunities to produce alpha. Specifically, this alpha may be produced (i) by investing broadly in Clean Tech versus the general market index, and (ii) by investing actively within the sector.

Alternative Beta

We believe greater alpha will be produced by the Clean Tech sector (in relation to the general market) than will be produced by traditional energy because the market inaccurately values the long term favorable effects of rising oil prices and environmental regulation on the sector.

The rise of crude oil prices (from around $20 at the beginning of the decade to over $100 today) has improved oil companies’ revenues but also led to increased costs of production, potentially squeezing margins.  The effect of rising oil prices on the Clean Tech sector has been much more benign.  While it is true that Clean Tech production incurs some of the same commodity and energy costs as traditional energy, these are relatively minor as a percentage of total costs. Furthermore, higher energy costs just add to the business case for investing in alternative energy and energy efficiency.

And the gap in production cost trends between traditional energy and Clean Tech is only going to widen in the future.  While the oil industry has been forced, due to decreasing supply, to drill in increasingly difficult locations using increasingly expensive techniques (such as boiling rocks in northern Alberta and drilling through arctic sea ice), alternative energy producers are in no danger of running low on cheap sources of  wind and sun.  Indeed, with continuous technological improvements, the cost of clean energy production has nowhere to go but down.  We believe these trends that favour Clean Tech are yet to be accurately priced by the market (i.e., the market is simultaneously over and under-valuing securities in this sector). 

Traditional energy is also subject to regulatory and legal risks that are substantially avoided by Clean Tech, and which the market has not yet adequately priced.  Indeed, Clean Energy Trends’ March 2008 report states that “Citigroup, JPMorgan Chase and Morgan Stanley have issued strict new guidelines for coal investments” because “ investing in CO2- emitting fossil fuel generation entails uncertain financial, regulatory and environmental liability risks”. 

True Alpha 

But while we believe that investing in the Clean Tech sector can produce alpha vs. the S&P 500, the opportunities to profit from this alpha will likely be missed (to a large degree) by passive Clean Tech indices.  Why? Because of the inefficient distribution of information about the technologies, markets, and companies within this emerging sector. This inefficiency can and does lead to inappropriate valuations. 

The risk of inappropriate valuations is a particular concern in Clean Tech.  Valuations in this sector tend to be quite high (and volatile) because Clean Tech is an emerging industry that is fairly small and has high growth rates.  Consequently, the expected cash flows of businesses are heavily weighted to the future, and valuation depends critically on the risk levels (i.e. discount rate) that investors assign to these expected cash flows.  Further, there are a large number of competing technologies in Clean Tech, many of which have not had to prove their economic merit outside of the shelter of government subsidies and regulation and may not survive as more competitive markets develop.

Yet investors, much as was the case in the 2000 technology bubble may tend to underestimate the risks and assume high growth rates can continue for most Clean Tech companies, assigning inappropriate risk levels  (i.e. low discount rates and high multiples) to their valuation and opening up a source of alpha for more knowledgeable portfolio managers. The dependence of valuations on high-growth assumptions has lead Clean Tech stocks to be relatively high in beta compared to traditional energy
These downside risks of the high growth assumptions and high beta returns can be seen in the major declines (30%-70%) in the overvalued solar energy segment during 2008.

Passive indices (such as the CTIUS) are more vulnerable to inappropriate valuations because they typically do not adjust weights for performance.  As a result, stocks that achieve high valuations often gain higher weights in indices over time [ed: see related posting on fundamental indexation].  Naturally, actively managed funds can add alpha by taking profits at high values and investing in the less-appreciated technologies that could be the next big winner, and by avoiding the downside risks of higher valuations. 

In conclusion, while it’s true that Clean Tech has not produced alpha vs. energy ETFs over the past 2 years (as Alpha Male’s analysis suggested), the fundamental economic drivers of the sector and the inherent informational inefficiencies that characterize it mean that Clean Tech represents a fertile hunting ground for alpha going forward.  Like any new and emerging market, active management has the potential to yield significant amounts of alpha for an investor capable of generating and sustaining an informational advantage.  And that’s a lot more than can be said about more mature markets such as US equities or, more to the point, the XLE.

- G. Payne, March 25, 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.  

 Email this post to a friend   Print This Post 

One Response to “A Reader Responds: Yes, there is Alternative Beta (and Alpha) in Alternative Energy”

1. allaboutalpha.com: AllAboutAlpha.com Says:
   April 6th, 2008 at 9:08 pm

   […] After the huge interest in last week’s commentary by clean tech investor Investeco on alternative beta in alternative energy, we dispatched our intrepid “fly on the wall” (see his previous posting from London) to one of the biggest events on the clean tech investing calendar, the Wall Street Green Trading Summit.  We asked him to report back on any new markets that were ideally suited for an alpha-centric investor.  Here’s what he found…    […]