Strategy and focus drive differ-ences in performance and prospects among green funds and ETFs.

Being green was easier this year than last, but that doesn't mean environmentally focused mutual funds and exchange-traded funds are playing on a level field as 2009 draws to a close. The extent of the damage from 2008, the strength of the rebound this year, and prospects for 2010 depend largely on how a particular investment fulfills its mission.

In last year's brutal market, smaller companies that dominate the volatile alternative energy space received some of the hardest blows, and the casualty list among alterative energy funds and ETFs ran long. Some lost over half their value in 2008, and many surpassed the devastating 40% decline in the Nasdaq Composite Index.  

Noticeably absent this year are runaway rebounds among such offerings. Because they fell so hard last year, some expected an equally powerful bounce-back in 2009. But that hasn't happened, at least so far. The granddaddy of the alternative energy ETF group, PowerShares Wilderhill Clean Energy Portfolio, rose more than 58% in 2006, outperforming the Nasdaq Composite Index by nearly 48 percentage points and opening the door to a flood of alternative energy ETFs. But it lost over two-thirds of its value in 2008 and has been doing only slightly better than the overall market so far this year.

Performance among the growing number of single-industry green alternatives showed that even among a narrowly focused group, investment results can vary widely due to differences in portfolio composition and index construction. Among water infrastructure plays, one of the newest and most popular areas for investment, returns for the first three quarters of 2009 ranged from 11% for PFW Water, a small mutual fund, to 35% for PowerShares Global Water, a popular ETF.

Tough Sledding For Alt Energy
Until credit financing opens up, smaller companies that dominate the alternative energy space are likely to face tough sledding, says Bozena Jankowska, manager of Allianz RCM Global EcoTrends, a mutual fund. In the past, 80% of the alternative energy projects were funded with cheap debt, she explains. But with tighter credit restrictions choking off that source of funding, expansion and growth have proved extraordinarily difficult. At the same time, falling stock prices discouraged venture capital and private equity investments. By late 2008 and early 2009, the extent of the damage became apparent as clean energy companies were forced to postpone or ditch projects and lay off workers.

Rising oil prices won't necessarily help these companies, says Jankowska. "The key to a clear revival will be evidence of available financing. Some money is starting to flow through to these companies from government stimulus packages, and that is encouraging." The U.S. government appears to be moving in the right direction, she says. In July, the Department of Energy outlined the application process to receive grants for renewable energy projects, which she considers "a significant step forward."

As alternative energy companies scramble for funding and await favorable government intervention, other challenges loom. Solar energy has received less government support for projects in Germany and Spain, two former strongholds for solar energy development. At the same time, China has recently flooded the market with inexpensive solar equipment. The new source of competition has driven prices down and put pressure on European manufacturers. Wind energy companies face fewer competitive issues, but still have trouble raising financing.  

Longer-term trends for alternative energy offer some encouragement. A report from CleanEdge projects that new installation costs for wind power will grow to $139 billion by 2018, up from $52 billion in 2008. Solar photovoltaics will grow from a $29 billion industry last year to $80 billion by 2018.  Although 2009 was a year for consolidation and retrenchment for many firms, the report notes that "new government spending, regulation, and policies should help the sector weather the current economic crisis better than most sectors."

Another optimist is Winslow Green Growth Fund manager Jack Robinson, who believes that alternative energy companies with proven products are in better financial shape than some analysts think. "Credit financing is opening up for companies that have proven technologies and economically viable projects," he says.  

Rising oil prices may also be a harbinger of better times. While last year unraveled the presumption that such pricing increases are always good news for alternative energy stocks, they could provide support for a rally at some point.

Gaining Traction
More diversified green funds that found a shallower bottom in 2008 did not have to climb out of so deep a hole as many of those with a narrower focus.  Portfolio 21, a mutual fund that invests in a wide swathe of larger companies with particularly strong environmental criteria, outperformed the Standard & Poor's 500 Index last year and is doing so again in 2009. Green Century Equity Fund, which screens for the most environmentally responsible companies on the FTSE KLD 400 Social Index, has also proved less volatile than more narrowly focused funds and is also beating the index.

With a presence in a broad range of sectors such as waste and water management, environmental services and green building provided some diversified funds with a support net last year and are giving them a boost in 2009. While all these companies have a common denominator of environmental emphasis, they represent a diverse range of businesses and sectors. Some stocks in fund portfolios, such as recycling companies and green building products manufacturers, fall into the cyclical industrial category. Other sectors, such as alternative energy, represent special situation growth opportunities.

One diversified green fund, Winslow Green Growth, returned to form in 2009 after a sharp downturn last year battered many of the small-cap stocks it invests in. Stock of top holding LSB Industries, whose subsidiaries specialize in chemical and climate control products, nearly doubled from the beginning of 2009 through mid-September after a 70% plunge in 2008. Renewed demand for raw materials also drove stock of leading metals recycler Sims Metal Management higher. Other top performers in the portfolio include energy technology company American Superconductor, which benefited from policy and economic shifts toward clean energy and resource efficiency.

Robinson observes that increased demand for services makes recycling businesses such as Horsehead Holding Corporation "the most interesting area to us right now." The company, a leading provider of zinc in the U.S., extracts the metal from steel industry byproducts and sells it to manufacturers who use it to produce galvanized steel.

Another diversified environmental fund doing well this year, New Alternatives, has been around since 1982. Managed by the father and son team of Maurice and David Schoenwald, this world stock fund invests in a range of industries that are involved with maintaining a sustainable environment, including wind generation, natural gas production and water utilities. But it occasionally looks beyond the obvious by investing in companies such as Panasonic, which makes batteries for hybrid cars, and insulation company Owens-Corning.  The fund has a social component and screens out companies with bad records for discriminatory labor practices, employment of children and animal testing practices. Weapons manufacturers, tobacco and gambling companies are also excluded.

Portfolio 21 has one of the more encompassing-and some might say looser-definitions of green. Unlike its competitors, the mutual fund has little presence in companies involved directly in environmental activities. Instead, it widens the net by screening for companies in a broad range of industries with the strongest environmental track records.

A look at the portfolio underscores management's contention that companies need not have an explicit environmental mission to be environmentally responsible. Top holding Google is committed to managing energy use and carbon emissions, and has equipped its headquarters office with solar panels and offers organic foods in its cafeteria. British Land, a property management and development company in the U.K., considers transportation, environmental issues, energy efficiency and materials selection in its new developments. Sweden's Electrolux gets the nod for making some of the world's most energy efficient appliances.

Core Holdings, Special Situations
Differences in the composition and performance of green investments make some of them more suitable as diversified core holdings, and others a better bet as environmentally friendly but more aggressive special situation investments, says George Gay, chief executive officer at First Affirmative in Colorado Springs, Colo.  Gay, whose firm specializes in socially responsible investing, considers Portfolio 21 a good core holding and one of the better performers in the world stock group. He also likes New Alternatives as a core world stock position, although he uses it less frequently because it is not on Schwab's OneSource platform.
Winslow Green Growth fits the bill as a core position for small caps.

Gay uses the PowerShares WilderHill Clean Energy ETF for clients with some tolerance for risk, but keeps such volatile sector ETFs and funds to no more than 5% to 10% of assets. Client reaction to last year's debacle among alternative energy plays was mild compared to what it could have been had he not warned them about the risk/reward characteristics of the newer, smaller companies such ETFs invest in. "Some people got nervous and pulled out when the market fell," he says. "But the reaction was far less severe than you'd expect."

In addition to discussing potential volatility, Gay also warns clients about the passive nature of ETF investing and the absence of broad social screens among most of them. "These aren't investments you want to recommend to clients who have strong concerns about labor practices among Indonesian solar panel manufacturers," he says.