PowerShares WilderHill Clean Energy (ETF) (PBW): This ETF Is a Case Study in “De-worsification”

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Recently, I made the argument that PowerShares’ Water Resources ETF is poised to beat the market thanks to inevitable trends in demand for fresh water. However, the benefits of owning a diversified basket of stocks that can take advantage of global trends will only lead to market outperformance if you take time to develop an understanding of the ETF’s components, the weighting of specific companies (or particular niches within an index), and the sensitivity to risks that can adversely impact an entire industry.

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Investment in clean energy

The world’s growing emphasis on, and use of, clean energy has been a long-followed story that most people believe will continue in the future. Does this qualify as the basis of a broad investment thesis similar to the growing demand for water? Perhaps, but further analysis is warranted. With this in mind, here is a deeper look into PowerShares WilderHill Clean Energy(ETF) (NYSEARCA:PBW). To start, here’s a five-year chart showing PBW’s performance in relation to the S&P 500:

PBW Total Return Price data by YCharts

Ouch! This chart shows why PBW represents my personal worst CAPS call of all time with a current score of -122. For those that haven’t tried it, CAPS is a great way to learn valuable investing lessons while keeping score, yet without risking real money.

So what caused the gap between a solid big-picture thesis and actual results?

Sometimes the big picture isn’t enough

In hindsight, a lot went wrong to drive PBW’s massive underperformance. At the top of the list, macroeconomic conditions and government budget crises put many clean energy projects on hold as subsidies dried up and more cost-efficient (and less green) energy projects were chosen. With the pressure of budget constraints and lack of government subsidies, green energy projects focused on solar, wind, and other sources quickly lost momentum.

Clearly, clean energy initiatives have not gone away; however, the funding behind many of the projects has either been postponed or reduced. Energy efficiency solution provider Ameresco Inc. (NYSE:AMRC) is an excellent example of how delays have plagued PBW’s holdings; the company reports an ever increasing backlog, yet has struggled to convert this backlog into revenue (and earnings).

Competition in the larger energy industry has further pressured clean energy providers, resulting in pricing pressure that has significantly hurt the sector’s ability to increase profits. Solar module maker First Solar Inc. (NASDAQ:FSLR) is a well-publicized case study in how competitive pressure combined with overcapacity can result in disastrous investment returns.

Another important consideration for investors contemplating an investment in a focused ETF like PBW is a thorough understanding of how the ETF’s holdings are weighted. At the ETF’s peak in late 2008, the ETF and the Wilderhill clean energy index that it seeks to track were heavily weighted towards solar-related businesses, with most of the top 10 holdings focused exclusively on solar. While this may not have seemed to be cause for concern at the time, it certainly should have been; the performance of First Solar and other top holdings such as Trina Solar Limited (ADR) (NYSE:TSL), JA Solar Holdings, Ltd. (ADR) (NASDAQ:JASO), Suntech Power Holdings (NYSE:STP) , and Yingli Green Energy Holding, which collectively accounted for 20% of the ETF’s holdings as of May 2008, are the primary reason PBW has performed so poorly as illustrated below:

FSLR Total Return Price data by YCharts

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