Market Thinking

making sense of the narrative

A Sustainable Bubble?

We have noted on many occasions the seemingly unstoppable trend towards a ‘green’ takeover of the western economy consistent with a centralisation of the allocation of capital according to the UN sustainability agenda. This risks high volatility and stock specific risk to investors as funds chase stocks deemed ‘suitable’ based on screening and weighting and regardless of fundamentals. In so far as investors continue to have a choice of where to allocate their capital we would recommend scrutiny of the Thematic (what is sometimes termed Smart Beta) Funds on offer in this area, both active and passive, in particular the fact that they are taking considerably different risk than the broader indices that their marketing departments would have you compare them with.

Sustainability may be here to stay, but how Sustainable are many Sustainable Stocks?

It was interesting to see things getting back to ‘normal’ (or maybe the new normal?) on Tuesday with remarks by Fed Governor Brainard that the Fed would be establishing a Supervision Climate Committee (SCC) and a Financial Stability Climate Committee (FSCC) in order to assess the Financial stability risks associated with Climate Change. Apparently. Rather like ex BoE governor Mark Carney, who is now anointed the UN Special Envoy on Climate action and Finance (and who is currently pushing his new book) and also the WHO, which a few years ago declared that the biggest health threat the world faced was Climate Change (really should have stuck to their day job), Central Bankers are seeing the way the political and economic winds are blowing and are rushing to join in.

Less Herd immunity and more Herd behaviour

While it seems from this statement that the Fed are thinking of problems for insurers caused by more ‘climate related’ incidents such as forest fires and flooding, (even though the notion that these are anything to do with Climate change are flatly contradicted by on the ground experts and also by the IPCC itself) it is highly likely that the Federal Reserve has a keen eye on the upcoming lucrative ‘Carbon Trading’ markets. This then is the prospect of, yet more, socialisation of risk and privatisation of returns and, yet more, financialisation of the economy as Wall Street crowds in to extract as much rent as possible from the new Green Economy.

“Carbon Credits? Come on Board, sit up next to the ESG guys”

Asset Managers are already fully on Board

In many senses they are already lagging behind the Asset Management businesses, who over the last five years have embraced the Green Economy wholeheartedly via the world of ESG and sustainability – as noted on many previous occasions. Our eye was caught particularly this week by the announcement by ace fund marketers Pictet that their Global Environmental Opportunities fund was to ‘soft close’ at $8bn.

Pictet also has a Global Clean Energy Fund that is $4bn in size (and still open), while the linked CityWire story also mentioned the Nordea Climate and Environment fund and the BNP Energy Transition fund, both closed at $7bn and $4bn respectively. Our first thought was that these four funds alone represent $23bn chasing a relatively similar and select group of stocks, representing a similar concentration risk to the Ark innovation fund that we discussed last month where fund inflows create forced buying of certain stocks – with of course the reverse being true for outflows. An obvious one here is Vestas, the Wind Turbine manufacturer, which has almost doubled in market cap in the last 18 months (we would say as a result of this sort of flow effect) and sits as a major holding for most of these types of funds. Whether a forward earnings multiple of 40x is warranted for a business operating on 5% net Income margin is an altogether different question (presumably one shared by anyone tracking the Danish market where it is over 10% of the benchmark). Similarly with Solar panel company Enphase, also widely held, whose market cap has gone from $2bn to $22bn in the last 18 months and sits on a forward multiple of over 100x.

This is not to have a go at these (huge) funds per se, rather the manner in which they are presented to investors by the Fund Management (marketing) industry.

Chart 1: Clean Energy and Environmental Funds had a Great Year in 2020

MXWO is benchmark MSCI World. January 2018 =100

We can see from the chart that over the last three years the two Pictet Funds (Environmental Opportunities in white and Clean Energy in yellow are up 45% and 62% respectively, while the Nordea Fund is up 52%. This, the marketing people will tell you breathlessly, is ‘beating the benchmark’ MSCI world, by anything between 16% and 32% and thus well worth the fees. It is worth noting here that according to Bloomberg the total expense ratio on the Global Environmental Opportunities Fund is over 2%, while on paper at least it has a 5% front end fee and a 3% back end fee (although most platforms and banks can negotiate some or all of this away). Even so, the 1.6% management fee on $8bn is highly attractive! Incidentally ‘soft close’ is largely a marketing ruse to drag in a few more people by making them feel ‘special’ as most large asset management firms are in reality asset gathering firms.

To stress, we are not picking on these funds in particular, it is simply because they are both large and in the news, the problem that we have is that the comparison with the benchmark is not really ‘fair’ since these funds are taking very different risks. For comparison therefore we have used the total return on the S&P Global Clean Energy Index and looked at the funds relative to this benchmark over the last three years as a ratio indexed to 2018 = 100. Hmm.

Chart 2: A Clean Energy Benchmark makes for a less flattering Comparison

One might argue that you can’t buy the Clean Energy Benchmark index – and thus you have to use these funds – but that is not correct. One example is the I-Shares Global Clean Energy ETF. This is one of the ETFs that we have in our thematic fund Model Portfolios and is designed to track this benchmark for a charge of 65bps (the fact that its risk has been rising and we have rotated away from it in recent months is another reason that this story on the soft closure caught our eye). As such we have rerun the first chart with this ETF added. Every picture tells a story as they say.

Chart 3: A tracking ETF for Clean Energy tells its own story

To repeat, this is not to pick on individual funds or to boost I-Shares trackers at the expense of other, active, managers but rather to make the point about so called Smart beta or Thematic strategies; their worth should only be judged against a relevant benchmark that takes similar risks. Fine if you want to take the risk, then decide the best way to do it.

Concentration Risk the unspoken risk in ‘sustainability’

In this case, one of the bigger risks being taken is concentration risk. We note for example that while the Pictet Environmental Opportunities Fund does not own Plug Power, the Hydrogen Fuel cell maker, it is currently the biggest weight (>7%) in the S&P Clean Energy Index tracked by the I Shares ETF, as well as in the BNP Energy Transition Fund (as is Enphase). Like so many of these stocks this has little or nothing in the way of earnings and trades on highly extended multiples, having gone up many multiples in terms of price over the last twelve months. Tesla has been a laggard by comparison! The fact that the South Korean SK group took a 10% stake in December may be important from a strategic point of view, but will undoubtedly have represented a distortion to the share price that may not be acknowledged properly by the Index and the index trackers.

To Conclude: Our view is that these thematic future growth stocks, particularly in the clean energy space can be a useful part of an investment portfolio, but should be recognised as high risk/return rather than owned, often unwittingly, as part of a ‘sustainable growth portfolio’, where the word sustainable is often conflated to imply sustainability of growth when in fact these are often highly speculative ventures. We would have them as part of a diversified portfolio of similar themed stocks (hence our preference for the lower cost ETF equivalent), but would also diversify away from this single theme to other growth themes and balance among those themes with a clear and constant eye on risk and return.

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