Green energy is the next big thing. But is it a right time to invest?

• One of the best performing funds on the platform year-to-date. Up 95% (in SGD terms on a year to date basis, as of 21 October 2020)
• An antithesis to traditional energy companies – instead of drilling oil from the ground, green companies are focused on renewable and sustainable energy technology and solutions
• We reckon the low interest rate environment has sent investors flying towards secular themes, one of which is the theme of green energy
• The theme is highly momentum driven, and it appears that the easiest part of the trade is over. Therefore, investors should be cautious of chasing performance at a juncture where its highly promising narrative is way ahead of the industry’s fundamentals
• We caution against a lump-sum investment into this theme at this juncture after a massive run up. Green energy has long term potential and investors should consider a regular savings plan instead

Thematic funds have had a hell of a year. And we meant it in a positive way. The best 25 performing equity funds on a year-to-date basis (as of 21 October 2020) generated returns anywhere from 30% to 100%. Certainly, it is a bizarre observation for many investors who haven’t had the time to tune into financial markets recently. You would be forgiven for thinking that equity returns across the board thus far have been poor.

Figure 1: Top 25 fund performances on iFAST funds platform

Source: iFAST

Data as of 21 October 2020

Amongst the top 25 best performer, many of them are related to specific themes. Of which, the most popular are those related to technology. The sector has been a major beneficiary as adoption of trends relating technology and digital economy accelerated during the pandemic. The usage of technology no longer lies solely within the Information Technology sector. Technology is now an enabler of disruptive innovation across many sectors and industries as traditional businesses are forced to adapt or die. The energy sector is also facing disruption – one under-the-radar segment that has outperformed in a significant way, is the theme of sustainable energy.

Why sustainable energy as a theme has outperformed

In an era of green activism, Greta Thunberg, and wide acknowledgement of the Paris Accord, is it a surprise why the share prices of green energy companies have moonshot? Market participants are pricing in a scenario of which the use of fossil fuels will be massively reduced to the benefit of cleaner forms of energy over the next two to three decades. It is estimated by PwC that US$29 trillion will be invested into green solutions by 2050, highlighting the immense potential the companies within this theme possess from an economic standpoint.

As you can see, the ETFs engaged in the green energy movement have had a stellar performance over the past year, returning anywhere from 50% to 150%, depending on the benchmarks used. Solar companies have done particularly well as investors realise their commercial applications are far more promising than other types of renewable energy.

Figure 2: Some green energy related ETFs on iFAST's investment platform have performed beyond investors’ expectations

Source: iFAST

Data as of 21 October 2020

What about actively managed strategies?

BNP Paribas Energy Transition Classic USD is one actively managed strategy that has managed to ride on this green wave. Benchmarked (but unconstrained) to the MSCI AC World Index, the fund offers global equity investors an opportunity to gain exposure to this fast growing space. The fund’s objective is to invest in the decarbonisation (renewable & transitional energy production), digitalisation (electrification technology & energy efficiency) and decentralisation (energy infrastructure & transportation) of the global energy system. Therefore, much of the fund’s exposure is centered on the industrials and utilities sectors; the direct producers and users of green technology.

Table 1: Fund sector exposure

From a geographical perspective, the fund is much more diversified than the global equity benchmark. That’s partly because opportunities within the green space are not centered in the US unlike the Big Tech firms (Google, Facebook, Amazon, Apple & Microsoft). Arguably, sustainability issues and green energy are more pressing matters for policymakers in Europe and China.

Table 2: Fund geographical exposure

Source: BNP Paribas Asset Management

Data as of 30 September 2020

Where the fund’s returns come from

BNP Paribas Energy Transition Classic USD seeks to outperform the benchmark by 4% p.a. over a 3 to 5 year cycle. The question is – where will the excess returns come from? The fund’s investment team achieve alpha using a four pronged approach; (1) Macro, (2) Themes, (3) Stock Research, and (4) Sizing & Trading. The fund works a little like a sustainable energy hedge fund.

They do whatever they can that adds value to the investment process, be it top-down macro, bottom-up stock picking, understanding industries & regulations governing them, and sizing the trade right to obtain optimal risk-reward. One thing to note, however, the fund is a long-only portfolio and does not engage in short selling for investment profit.

From a valuations perspective, the fund can be construed to be quite expensive. Based on its latest reporting date, the portfolio traded at a Price to Cash Flow of ~15X, a valuation metric that would take many years of exponential growth to justify. However, such expensive valuations is consistent across the entire green energy complex (especially companies involved in solar photovoltaics), and not just unique to BNP Paribas Energy Transition Classic USD.

Chart 1: BNP Paribas Energy Transition Classic USD’s performance skyrocketed against the global equity benchmark

Significant risk factors the fund is exposed to

Breaking down the fund’s returns into factors (using Bloomberg’s factor risk model) over the past year, Momentum is arguably the biggest active risk factor contributing to the fund’s active returns. It explains return differences of stocks based on their recent relative performance.

In the current low market environment, green energy stocks continue to perform strongly in the face of an ongoing economic recovery as well as continued long term global interest in sustainability solutions. As powerful it is in driving short term returns, Momentum can be a double edged sword. Its nature is fleeting, and can disappear quickly and work against investors.

Size is another significant driver of active risk. It captures systematic risk differences between small and large caps. Many of the green energy companies are essentially small to mid-cap companies. With smaller firms, there is always greater room for growth, and therefore higher potential for greater returns. This however, comes at the cost of enduring higher volatility and drawdowns throughout the investment horizon. And unlike large cap companies, green energy stocks are generally less liquid.

Table 3: Return & risk metrics versus benchmark and other green energy peers

Source: Bloomberg Finance L.P., iFAST compilations

Data as of 22 October 2020. (A) refers to annualised.

Why choose active over passive exposure

There are different catalysts and risks for the varying green energy sub-industries. Sometimes, these industries can run into overcapacity. It happened a few years back with solar energy when China flooded the market with low-cost solar panels, leading to a collapse in its price. Unless you are one to watch the green energy sector closely, we believe any negative developments can be better managed by a professional team. A buy-and-hold passive exposure to the sector (via ETFs) does not have that anticipatory potential.

Setting expectations right

Expectations are important when it comes to investing. If you are one hoping to chase this theme in hopes of near term profits, then perhaps you are a little late. Given current valuations, it is likely that the easiest part of the trade (riding the momentum up) is over. But here’s the good news: sustainability as a theme is likely to endure for many years to come.

Green investments have often been touted as one way to stimulate growth by both the public and private sector. As governments place more emphasis on green energy, more investments will likely flow into the green energy industry, creating jobs and economic opportunities for the global economy, creating a real case for investing in this theme for over the long term.

But we certainly have to balance its future potential with current valuations. As we have mentioned, the industry is trading at valuations that are difficult to justify right now. Therefore we do not advocate a large lump sum investment into this fund at this juncture. Unless investors have superior analytical ability or knowledge to time their entry, a regular savings plan strategy would probably be a more prudent option.

On a related note, back during the late 90s era, the hype was all about internet stocks. But if you think about it, real applications and the usage of the internet came about in a big way only a decade after, with the evolution of social media and e-commerce. It could be the same with green energy stocks; while it has a lot of interest now, it could be long before the proportion of the world’s energy usage comes predominantly from renewable energy. Therefore, a long term investment horizon is always the minimum requirement for any investor in the green energy space.