Is there alternative beta in alternative energy?

CAPM / Alpha Theory 26 Nov 2007

We’re always on the look-out for new and different market risk factors or betas here at the AllAboutAlpha global headquarters.  So with all the talk recently about alternative energy (such as a session at this Toronto energy conference next week hosted by AllAboutAlpha media partner Lipper HedgeWorld), we started wondering if there was actually a market risk factor associated with so-called “clean energy” companies that was separate and distinct from the energy factor itself.

We found this article in Forbes late last month exemplified the general level of excitement about alternative energy.  It cites impressive YTD growth of several alternative energy ETFs such as the US$660 million PowerShares WilderHill Clean Energy ETF (PBW).  This makes immediate sense.  After all, clean energy is the next big thing, right?

It turns out that PBW daily returns have a 64% correlation to the S&P Energy Select SPDRs (XLE), an ETF containing old-fashioned energy companies (calculated using data available at Google Finance).  That’s not really that high.  Here’s what the one year scatter plot of PBW and XLE daily returns looks like:

Unexplained (alpha) returns of 3bps per day or around 8% per annum may sound pretty good, but compared to daily the volatility of nearly 2% (nearly 30% per annum), it loses its luster a bit.  (If you’re keeping score at home, you might have noticed that the compounded returns of the XLE and PBW are still roughly equal since the higher volatility of PBW got the better of its meager monthly alpha along the way).

Okay, we thought, maybe one-year is too short a time horizon to gauge the inter-relationship (or lack thereof) between clean energy and the dirty stuff.  So we performed the same analysis over two years.  Here is the result:

The correlation drops to around 53% and the daily alpha drops to close to 2bps with basically the same volatility as the one year analysis.

So what is PBW adding to the equation?  If you shorted out the XLE exposure within PBW to get the “unexplained” returns of PBW (it’s alpha and error term in the CAPM) you’d get:

And that is what you’re essentially buying when you buy the PBW because that is what you can’t already purchase in the form of the XLE.  When you look at a two-year horizon, it would appear that the PBW is essentially an XLE with “noise”.  So a passive PBW position would have left you in basically same position as a passive position in the XLE (with more volatility along the way).

This back of the envelope analysis doesn’t preclude the possibility of alpha in the future, however.  After all, clean energy is a secular trend.  So, as proponents suggest, it may perform in the future in ways we have not seen in the past.

Also, we have been in a bull market for energy over the past several years.  A bear market (if it ever happens again), could see clean energy assume a lower volatility.  High beta in a bull run and low beta during a bear market could result in significant alpha if we were to run these analyses again in a few years time.

Then there’s the question of the appropriateness of the XLE benchmark.  One might argue that a more tech-heavy benchmark is appropriate here.  That could yield dramatically different alphas.

In addition, there are periods within the two-year return cloud where PBW beat XLE, and periods where the opposite was true.  Analyzing such periods could yield significantly positive (or negative) alphas.  However, an active position in the PBW could, in fact, outperform the XLE if you know what’s really going on in the “unexplained return” cloud above.  Decoding the random cloud of “XLE-deviations” maybe a pretty good reason to go to that Lipper HedgeWorld event.  You can also pick up some Canadian petro-dollars while you’re there.

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  1. Tom Konrad
    November 30, 2007 at 1:07 am

    There’s one other thing you’re buying with clean energy: the ability to feel better about your investments. It may not make you extra money (although I believe it will with increasing GHG regulation), but knowing you’re doing the right thing is worth a lot to some of us.

  2. Steve Orr
    December 8, 2007 at 8:07 am

    I disagree that PBW is XLE + noise. Beyond a clean energy play, ETFs like PBW reflect the need for energy development in general. It is likely we will be using more energy from all sectors in a growing global economy. The future will be more cars, planes, trains, houses, iPods… using energy more efficiently. We will need every solar panel, every acre of sow bean, every nuclear power plant, every wind turbine and every barrel of oil that can be extracted out of the ground. The rate limit to the next large scale global growth will be true fundamentals — water, soil, land, industrial materials. Very few current in-place energy systems will be replaced. We will mostly add to the existing supply of energy. In regions of the world where it is expensive and time consuming to create large distribution networks for gas pipelines and electric grids – pocket-sized small regional grids with windpower and solar will be installed quickly and get people up-and-running much faster than a coal burner or a gas pipeline. As commodity prices continue to rise both XLE and PBW and others like them will rise with the rising tide of worldwide energy demand. Personally, I was hoping that Chavez would refuse to sell oil to the US as it would send markets even higher for both sectors and force a better energy security development for resource-poor nations (such as the US). As usual, politics will play a complicated and complicating role in the modification of these models. Much of the world’s oil is in the hands of people that are highly motivated to deploy their own agendas. Alternative energy technology development is in the hands of scientists and engineers who are rapidly working the problem and are highly motivated. Altertive energy sources will play an increasing role in energy deliver as oil becomes more expensive to extract from more difficult locales. In aggregate both sectors will go up as demand contnues to grow.

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