SMOG: Macro Headwinds Make This Low Carbon Energy ETF Hard To Inhale (NYSEARCA:SMOG)

The VanEck Low Carbon Energy ETF (NYSEARCA:SMOG) invests across renewable energy companies as well as leaders in related environmentally friendly technology. This is a segment that has grown significantly in recent years, but underperforming following what was a short-lived pandemic boom. Indeed, the latest headlines aren’t helping.

Solar stocks within the SMOG portfolio are facing a major selloff with several category bellwethers warning of weak demand despite global to government-backed efforts to incentivize clean energy technology. Wind energy stocks have not been any better. Broader macro headwinds including rising interest rates have pushed SMOG down by more than 25% since its September high.

That being said, we can highlight that SMOG has at least fared better than many alternative “clean energy” ETFs with a narrower decline this year, largely related to the fund’s position in Tesla Inc (TSLA) as its top holding. Still, even TSLA is under pressure following its latest earnings report which now opens the door for SMOG to be dragged lower.

We think SMOG can work for investors in the context of a diversified portfolio over the long run, but expect the current volatility to extend through 2024.

What is the SMOG ETF?

SMOG is intended to track the “MVIS Global Low Carbon Energy Index” including companies that generate at least 50% of their revenue from renewable sources of energy and related activities or benefits directly from those technologies.

Naturally, wind and solar power firms are the clearest examples of “low carbon energy”, but that also includes hydrogen, bio-fuel or geothermal technology, lithium-ion batteries, electric vehicles, smart grid technologies, and even environmentally friendly industrial materials that reduce carbon emissions or energy consumption. By this measure, SMOG takes a broad interpretation of this theme.

It’s worth noting that SMOG’s strategy features some global diversification. U.S. companies are currently 35% of net assets, but there are also clean-tech leaders from China at 20% and European names covered.

With a modified market-cap weighting methodology, Tesla Inc. stands out as the largest position in the fund with an 8.5%. Technically, there is an 8% cap on all holdings which is rebalanced quarterly.

Utilities are the most well-represented sector in the fund at 37% of the overall weighting. This includes names like NextEra Energy Inc (NEE), the largest utility-scale solar generator in the United States, along with Spain-based Iberdrola SA (OTCPK:IBDSF) both with a 7.5% weighting.

Down the list, we find more specialized names like China EV makers including BYD Co Ltd (OTCPK:BYDDF) and Li Auto Inc (LI). U.S. solar stocks like First Solar Inc (FSLR) and Enphase Energy Inc (ENPH) round out the top 10 holdings.

SMOG Compared to Other Clean-Energy ETFs

We mentioned that there are several different options for investors when looking at clean energy thematic ETFs. SMOG with current assets under management of around $150 million is still small compared to some of the alternatives including the iShares Global Clean Energy ETF (ICLN) with $2.8 billion in AUM.

That being said, SMOF is relatively unique in this category for including electric vehicles ((EVs)) as part of the same “theme” which comes down to semantics. We believe it makes sense that EVs are one of the most direct implementation and most widely visible clean energy solutions in a transition from fossil fuel so it makes sense they are included, in our opinion.

Other funds like the PBW Invesco WilderHill Clean Energy ETF (PBW) favor more technology names and industry suppliers while underweighting the role of utility stocks from clean energy generators.

The most direct comparison to SMOG is likely the Invesco MSCI Sustainable Future ETF (ERTH) which also holds TSLA and other EV stocks. That said, our criticism there is that the portfolio with 183 names may be a bit too extensive, and attempt to do too much by getting into segments we find more controversial including real estate and even data center providers within its theme of “sustainability”.

We can’t say one direction is better or worse than another but find that SMOG does a good job of finding this balance with a broad interpretation of clean energy through a targeted portfolio of 76 stocks covering the important category leaders.

Over the past three years covering the period since late 2020, SMOG’s -21% decline is less than half the drawdown the PBW ETF has faced and also narrower compared to the -26% decline in ERTH and the -34% loss in ICLN. Again, the inclusion of TSLA as its top holding is a big part of that spread.

What’s Next For SMOG?

The sentiment for SMOG and this segment of the market has been terrible. For many companies including utilities that are highly leveraged and depend on debt financing, global interest rates at a near two-decade high have added to the volatility alongside concerns of a global economic slowdown.

Outside of company-specific factors, the weakness in the solar market is a major development. The sense is that the demand for photovoltaic applications particularly on the residential side has disappointed, and is below prior forecasts. This comes at a time when the pricing for solar panels has dropped significantly, which might be great for buyers, but isn’t helping in terms of profitability for producers.

SolarEdge Technologies Inc (SEDG) which represents about 2% of the SMOG portfolio, for example, recently cut its outlook citing “substantial unexpected cancellations and pushouts of existing backlog”. The company is seeing higher-than-expected inventory and soft installation rates at the distributor level. Those comments echo trends from Enphase Energy, whose shares are down more than 60% in 2023 amid a sharp slowdown.

With the wind power industry, the story has been rising costs for the traditionally capital-intensive developments, pressuring margins. Even with EVs, several manufacturers including Tesla are hitting the breaks on aggressive expansion efforts with signs of cooling demand.

The setup here doesn’t instill much confidence over the near term for SMOG and the clean energy sector overall. That being said, investors can take some solace in the longer-term big picture.

By all indications, the transition to cleantech away from fossil fuel is a movement that can’t be stopped. EVs continue to gain share from internal combustion engine automobiles and the expectation is for solar power installations to accelerate over the next decade. The silver lining of the current selloff is that it sets up a stronger base of support in the underlying equities at more attractive valuations ahead of the next leg higher.

Final Thoughts

SMOG is a high-quality ETF that has performed exactly as intended by capturing exposure to companies best positioned to benefit from trends in renewable energy. Unfortunately, that momentum has been negative in 2023 against various bearish pressures.

We rate SMOG as a hold representing a neutral view over the near term, recognizing the current headwinds against what remains a more positive long-term outlook for the theme of low-carbon energy.

Amid the ongoing selloff, we’re eyeing a move in SMOF back to its pre-pandemic price of around $90.00 per share as the next level of technical support. In our view, it would take a deeper deterioration of the macro outlook along the lines of a sharp global recession for the fund and underlying holdings to break down significantly further.

On the upside, it will be important to see signs that demand for key technologies like solar is rebounding which can be monitored by reports from the leading companies in the sector. Stability in interest rates will also be key to watch into 2024.