Invest In Sustainable Energy With The SMOG ETF

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I like the VanEck Vectors Low Carbon Energy ETF (NYSEARCA:SMOG) because it’s a globally diversified ETF, representing 22 countries and five sectors. Furthermore, the increasing awareness of environmental sustainability is a potentially powerful tailwind for this part of the clean energy investment theme. SMOG has plenty of positive factors that could have prompted me to initiate coverage of it now. However, it has a history of wide price swings and isn’t sufficiently liquid. So, in the current indecisive and volatile stock market environment, I am limiting my rating to hold for the time being.

Strategy

SMOG was established in 2007. It’s a global fund, with investments in multiple countries and continents. SMOG invests in businesses that produce low-carbon energy. This segment of the energy sector includes activities such as the production of hydroelectric power, solar and wind energy, biofuels, fuel cells, independent power plants, lithium-ion batteries, alternative fuels, electric vehicles, and renewable electricity sources. SMOG executes its strategy through a process known as “full replication.” That means it aims to own every security in the index it follows in the same weighings as its benchmark index, the MVIS Global Low Carbon Energy Index.

Holdings Analysis

SMOG allocates across roughly 70 holdings. These are distributed across several sectors, including utilities, consumer cyclical, technology, industrials, basic materials, and real estate.

The fund has wide global coverage, with 22 countries represented. That said, the holdings here all draw more than 50% of their revenues from clean energy. As such, this ETF does not focus on the traditional energy sector at all. Traditional fossil fuel companies tend to not pass the screening and filtering process for SMOG.

Strengths

SMOG has outperformed the S&P 500 over the last couple of years with high total returns. The graph below depicts the five-year performance of SMOG and the S&P 500. Likely drivers of SMOG’s past outperformance of the broad stock market include growing awareness of initiatives taken by these types of companies, as well as increased support from Washington, D.C., to maximize the use of clean energy.

On the latter point, the Inflation Reduction Act focuses on the clean energy economy and promotes the growth of sectors involved in this type of energy manufacturing. That law, passed in August 2022, provides billions of dollars in loans and grants that will likely result in the financing and development of projects that cover a lot of ground in the clean energy business. Its goals include a reduction in greenhouse gas emissions, as well as the establishment of transportation projects in disadvantaged communities.

SMOG has done well in the past, but what about its future? That depends on how much volatility an investor is willing to take in order to participate in the growth potential of this niche ETF. It has shown the ability to put up big performance numbers in the past. Going forward, if the trend toward lower carbon emissions stays constant or increases, SMOG can be a market leader in more “risk-on” time periods.

Weaknesses

SMOG’s global diversification can potentially hamper returns. Less than half of the fund’s assets is invested in U.S. stocks, and Europe and Asia each represent more than 25% of this ETF’s allocation. There exists a real possibility that a carbon tax could be levied on all U.S.-listed companies in the future. That would likely impact performance, perhaps very suddenly.

SMOG’s 39% concentration in utilities is a potential risk for this ETF, as it would be for any diversified fund that relies so much on any one of the 11 S&P 500 sectors. This is not a temporary condition for SMOG, since its potential addressable universe of stocks that can meet its strict criteria is fairly small and focused.

Historically, this ETF has been quite volatile. It has had a 46% drawdown (peak-to-trough price decline) in its history. That shows that no matter how much these types of companies might have a long-term impact on planet Earth, the stock market will treat them as harshly as any other market segment when financial conditions get tighter. SMOG’s beta over the past five years has been 1.3, or 30% more volatile than the S&P 500. So this ETF is likely to be vulnerable to the most significant stock market declines.

Opportunities

With growing global awareness and focus on producing and using green energy, many countries and companies are investing in and implementing technology to reduce emissions. For instance, two of SMOG’s top holdings, NextEra Energy (NEE) and Iberdrola (OTCPK:IBDRY), have their own initiatives. In the case of NEE, that initiative aims to achieve “real zero,” which is to eliminate carbon emissions from its operations. In the case of IBDRY, the goal is to achieve emissions neutrality in the company’s generation, electricity distribution, and consumption plants by 2030.

The presence of stated long-term commitments from its biggest component companies gives SMOG a very wide scope of growth, as the world increasingly views climate risk as being equivalent to investment risk. In other words, we might be heading down a path where companies will need to be proactive in the carbon emissions area as part of retaining investor confidence. SMOG is in the sweet spot regarding that trend. In particular, utilities that focus on clean energy are a high-potential growth sector.

SMOG’s international exposure, as with many ETFs, is only as good as investor sentiment and price action toward non-U.S. stocks. That has a lot to do with the future path of the U.S. dollar. The dollar has had a remarkable run over the past few years. But if the recent reversal of that path picks up momentum, it should help globally diversified ETFs like SMOG.

Threats

This fund’s high standard deviation could be one of its biggest threats. A three-year standard deviation of 33% is quite high compared to 19% for the S&P 500 over the same period. In a stock market that has plenty of volatility on its own these days, SMOG adds some additional risk should the current bear market continue.

SMOG also has a rarity in today’s ETF market. Its asset base is over $200M, yet it has only around $500,000 of dollar volume on a typical day. So, investors managing very large sums of money for themselves or for others should consider this somewhat limited liquidity. This is not a great trading vehicle. Finally, SMOG’s expense ratio of 0.55% is a bit on the high side for an index ETF. However, the disciplined screening process involved, and the resulting portfolio justify that cost to me.

Conclusions

ETF Quality Opinion

SMOG follows an ESG thematic strategy, meaning it invests in companies that produce clean energy. I believe ETFs that are environmentally minded have tremendous long-term upside potential. I like the rules-based company selection and global diversification that this fund offers. I am including it as part of my watchlist of funds to keep an eye on.

ETF Investment Opinion

SMOG is an ETF I favor on a long-term basis. However, the current equity market environment prevents me from being more positive than a hold rating, which is what I assign here.