Inflation Reduction Act: 3 renewable energy ETFs to watch

Going broad to identify clean energy funds

Thematic investing doesn't require active management in the form of a fund manager picking individual stocks. Nowadays, the line between passive indexing and active management is becoming increasingly blurred, with many rules-based or quantitative methodology-based funds falling in the middle.

Investors looking for a more passive approach to their clean energy thematic tilt might like the iShares Global Clean Energy ETF (ICLN), which tracks the S&P Global Clean Energy Index. This ETF index holds a total of 98 global clean energy stocks, with 47% from the U.S., 11% from China, 10% from Denmark, and the rest from other countries. 

The clean energy industry is broad and comprises many sub-industries. In ICLN, the highest represented sub-sector is semiconductor equipment at 22%, followed by renewable electricity at 19%, and then electric utilities at 15%. In terms of sector exposure, we mostly see technology, industrial, utilities, and materials stocks. 

ICLN is the most popular clean energy ETF, having attracted assets under management (AUM) of $5.46 billion since inception. Be aware that the fund is fairly volatile, with a three-year standard deviation of 35.38% and beta of 1.13. In terms of fees, it charges a reasonable 0.40% expense ratio. 

Investing in solar energy with TAN ETF

Investors who want to take on more risk for the chance of higher returns can make a more concentrated bet on a particular sub-industry of the clean energy industry. The IRA will provide a 30% tax credit for 7.5 million families to install solar on their roofs, and a commitment of 950 million solar panels by 2030.

A good option here is the Invesco Solar ETF (TAN) which tracks the MAC Global Solar Energy Index. TAN uses an interesting "pure play versus medium play" methodology to screen and weigh its 55 underlying holdings. If a company has revenues from solar comprising a majority, it is categorized as pure play. If solar revenues only account for one-third, the company s designed medium play. 

Pure-play solar companies are weighted higher in the ETF. The top three holdings are Emphase Energy (ENPH), First Solar (FSLR), and SolarEdge Technologies (SEDG). Overall, the fund is skewed towards small and mid cap stocks, with a growth stock focus. The ETF has higher volatility as a result, with a five-year monthly beta of 1.47. 

Investing in wind energy with FAN ETF

Investors can also target the wind energy sub-industry of the clean energy sector. The IRA extended existing tax credit provisions for wind projects, which could incentivize further industry activity and development. Investors can gain wind energy exposure via the First Trust ISE Global Wind Energy Index Fund ETF (FAN), which tracks the ISE Clean Edge Global Wind Energy Index. 

FAN uses a similar pure vs. non-pure methodology as TAN to weigh its holdings. Companies with 50% of their revenues coming from wind energy are classified as pure play, while those with lower revenue exposure to wind energy are classified as diversified. Pure-play companies account for 60% of FAN by weight, with the remaining diversified companies accounting for 40%, each capped at 2%. 

Surprisingly, FAN is slightly less volatile than the overall market, with a lower five-year monthly beta of 0.94. The ETF is almost entirely utilities and industrial stocks, with a smattering of materials companies. The former tends to be defensive in nature, while the latter tends to be cyclical.

Historical performance of ICLN, TAN & FAN

I've provided a backtest of all three ETFs' performance versus the S&P 500 from 2009 to the present below. Keep in mind that these returns are hypothetical in nature, do not reflect actual investment results and are not guarantees of future performance. The hypothetical returns do not reflect trading costs, transaction fees, commissions, or actual taxes due on investment returns.

Please note this article is for information purposes only and does not constitute investment advice.