ICLN - ICLN: Bad Performance With Potentially Worse Outlook

2023-06-19 08:37:30 ET

Summary

• The iShares Global Clean Energy ETF has underperformed the S&P 500 and the iShares ESG Aware MSCI USA ETF while slightly outperforming the SPDR S&P Oil & Gas Exploration & Production ETF.
• ICLN has high sector concentration, with half of the fund NAV focused on Utilities, and its top 10 holdings make up half of the fund NAV.
• The outlook for ICLN is not promising due to its recent poor performance, concentration on overvalued utilities companies, and inability to capture potential upside from other forms of clean technology.

Over the recent years, sustainability-themed ETFs such as the iShares Global Clean Energy ETF (ICLN) have gained significant traction to capture the potential upside from investing in various sustainable/ESG stocks, especially the clean energy companies mainly included in ICLN.

ICLN invests in 100 clean energy-related companies tracking the S&P Global Clean Energy Index. According to S&P, the index is constructed using proprietary exposure score assignment to the clean energy industry (which therefore determines the weights of each security capped at 8%), while companies with significantly large carbon-to-revenue footprint on a relative scale are filtered out.

Hence, the fund is providing investors with reasonably maximized exposure to the clean energy industry without much consideration of financial materiality. This approach undoubtedly leads to high sector and security concentration, where about half of the fund NAV focuses on Utilities and its top 10 holdings also take up half of the fund NAV.

Performance & Risk Review

So, how has ICLN performed recently? Short answer is pretty bad . Looking at the YTD performance chart below, ICLN greatly underperformed SPY (S&P 500) and ESGU (iShares ESG Aware MSCI USA ETF) while slightly outperformed XOP (SPDR® S&P Oil & Gas Exploration & Production ETF) which has delivered massive returns in 2022 due to the energy crisis.

Recently, the fund has become much less volatile compared to previous years, where the standard deviation (gray part in the chart below) narrows and the fund is currently trading at its rolling 3-month mean.

Looking at its rolling CAPM Alpha & Beta relative to SPY over the 5Y period, it has been trading with a beta of nearly 1 over the past several months - indicating that ICLN moves closely along the S&P 500. However, its alpha has been poor with consistently negative figures which describe its underperformance over S&P 500. In short, the fund has become less risky (volatile) but with disappointing excess returns.

Deep Dives

Given its high sector concentration, it is worth looking at the sector returns to determine the performance driver for the fund. From the YTD performance chart below, Utilities and Industrials (both defensive sectors) have gone into negative territory, where ICLN tracks in between.

However, there is a different tale to be told on the opposite side, where the Technology sector significantly outperformed, driven by major tech names such as Nvidia (NVDA), Apple (AAPL), and Microsoft (MSFT). Since ICLN technology exposure is more related to the deployment of clean energy technologies, its performance deviated from the overall Technology sector.

Valuations of the underlying securities within the fund are also worth looking into. Although the fund in aggregate has a PE ratio ((TTM)) of 20 (slightly lower than 22 for SPY and 24 for XLU), some of the top holdings within ICLN are almost unprofitable.

For instance, FSLR (ICLN's largest holding) is on the edge of achieving profitability given its sky-high 472 PE ratio. Meanwhile, its second and third-largest holdings ( SEDG and ENPH ) also have very high relative valuations. Buying into a concentrated group of overvalued Utilities stocks under a high interest rate environment may be a tough sell.

Profitability prospects (as shown in the heatmap below) across the top holdings can vary significantly as many are yet to establish mature financials. For instance, return on equity ranges between 0.7 for FSLR to 75.7 for ENPH, while revenue growth ranges between 0.8 for ORA to 64.5 for ENPH.

Liquidity ratio would give a better overview of their financial conditions. Companies such as ED and ENPH with debt to equity ratio above 1 (meaning that amount of debt is higher than equity) may be concerned with rising borrowing costs. ED with a quick ratio of 0.8 (<1 indicates current liabilities are greater than current assets deducted by inventory) creates additional concerns over its liquidity position. However, both the quick ratio and debt to equity ratio do look reasonable across the top holdings, given the expected higher leverage to drive revenue growth.

Potential Tailwinds

Despite massive reduction in the cost of renewables with economies of scale, it may now rise due to supply chain bottlenecks and rising interest rates. With fixed-price power purchasing agreements, renewables developers such as Orsted (DNNGY) cannot easily pass the costs on to end consumers and the electricity prices offered to developers are now less lucrative. This would lead to a drop in renewables demand for utility-scale projects, which would adversely impact the rest of the clean energy supply chain being captured by the index.

Following the European energy crisis last winter, the priority of the bloc now is to achieve energy security by increasing natural gas processing and storage capacity, and potentially looking further into nuclear or hydrogen as part of the ultimate solution. This potential upside may not be captured by investing in ICLN as it focuses mainly on several renewable sources such as Solar, Wind, Hydroelectric, Biomass, and Geothermal. This is worth flagging to any potential investor on this fund thinking that all forms of clean energy would be captured here.

Conclusion

With that, the outlook for ICLN does not look lucrative given its recent disappointing track record, concentration on overvalued utilities companies, and the methodological shortage to capture potential upside through other forms of clean technology.

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