ICLN (ICLN): This Clean Energy Fund Is Not A Compelling Buy (2024)

Outlooks on the prospects for clean energy are famously volatile. Investors in solar energy refer to this as the ‘solar coaster’. Clean energy stocks shot up following Joe Biden’s election in November of 2020 and, later, in response to support for clean energy in the proposed Build Back Better bill. As the political challenges of passing major legislation have become evident, the clean energy stock prices have collapsed. The iShares Global Clean Energy ETF (NASDAQ:ICLN) shows this sequence of events. The 12-month price appreciation for ICLN is -3.08% and the YTD return is -18.56%. ICLN hit a YTD high close of $33.41 on January 7, 2021, and is currently trading 32% below this level, at $22.61.

1-Year price history and basic statistics for ICLN (Source: Seeking Alpha)

Over the past several years, ICLN has delivered high returns. The 3- and 5-year annualized total returns for ICLN are 39.96% and 25.57%, respectively. For context, QQQ’s annualized total returns over the 3- and 5-year periods are 36.27% and 28.51%.

Clean energy stocks have gotten a significant boost in recent years from three major trends. First, there is increasing concern about climate change among both individual investors and institutional investors. Second, there is broad growth in demand for socially responsible investments (ESG/SRI). Third, clean energy companies are increasingly popular as this category is somewhat conflated with tech growth stocks. Tesla (TSLA) is the prime example of this trend.

A notable property of ICLN, and clean energy in general, is that some of the companies included in the ETF portfolio have little in common. The largest holding is Enphase Energy, with a P/E of 75.19. The third largest is Con Ed, with a P/E of 18.02. Another attribute of ICLN is that the selection criteria for stocks can result in substantial shifts in holdings. A significant number of the top ten holdings were first purchased in the fund in 2021. This gives me pause for two reasons. First, this level of turnover (54%) is a concern because of the potential reduction in performance because of trading costs. This performance drag is due to direct trading costs, the bid-ask spread, and market impacts of trades. For context, the turnover in QQQ is 7.7% and turnover is 2% for SPY. It is reasonable to have more turnover in specialty funds, but the level observed for ICLN looks quite high.

Top ten holdings for ICLN (Source: Morningstar)

The 0.42% expense ratio is not particularly high for a specialty sector ETF, but is worth noting for those investors seeking to minimize costs.

One of the ways that I look at stocks and ETFs is by analyzing options prices and there are options on ICLN that can provide insight into how the options market sees ICLN’s prospects. The price of an option on ICLN reflects the market’s consensus estimate of the probability that the price of ICLN will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of calls and puts at a range of strike prices, all with the same expiration date, it is possible to calculate a probabilistic price forecast that reconciles the options prices. This is called the market-implied outlook and represents the consensus view of the options market.

The market-implied outlooks show whether or not there is some directional tilt in the options market, reflecting the consensus outlooks of buyers and sellers of options. In 2021, so far, the market-implied outlook for sector ETFs has had hits and misses. I also regularly run market-implied outlooks for broad asset class ETFs.

Market-Implied Outlook for ICLN

I have analyzed options on ICLN that expire on January 21, 2022 to calculate the market-implied outlook for the next 1.4 months (from now until that expiration date). I have also calculated the market-implied outlook for the next 13.3 months from now until January 20, 2022 using options that expire on that date. I selected these two dates to provide a near-term and 1-year outlook and because the options that expire in January are more actively traded than for other expiration dates, adding some confidence in the representativeness of the outlooks. I would like to have calculated a market-implied outlook near mid-2022 but the trading volume was thin.

The standard presentation of the market-implied outlook is in the form of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for ICLN for the 1.4-month period from now until January 21, 2022 (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook to January 21, 2022 is generally symmetric, with comparable probabilities of positive and negative returns, although the well-defined peak in probability is tilted to favor negative returns. The maximum probability corresponds to a price return of -1.8% for the next 1.4 months. The annualized volatility calculated from this probability distribution is 31%. For context, the annualized volatility I calculated for QQQ in a post in mid November was 28%.

To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for ICLN for the 1.4-month period from now until January 21, 2022. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

This view makes the tilt in probabilities to favor negative returns more obvious. The probabilities of negative returns are consistently higher than for positive returns of the same magnitude across the range of outcomes.

Theory suggests that the market-implied outlook is expected to have a negative bias because investors, in aggregate, tend to be risk averse and thus willing to pay more than expected value for downside protection (put options). There is no robust way to test for such a bias. The bearish tilt in the market-implied outlook is likely to be less significant than it appears if this bias exists. As such, I interpret the market-implied outlook to January 21, 2022 to be neutral to slightly bearish.

Looking out 13.4 months to January of 2023, the market-implied outlook is solidly bearish. The tilt in probabilities to favor negative returns is more substantial (the spread between the dashed red line and the solid blue line is more pronounced) and the peak probability corresponds to a price return of -10% for this period. The annualized volatility calculated from this distribution, consistent with the estimate to January 2022, is 31%. ETrade calculates implied volatility for ICLN for this expiration date to be 32%.

Even considering the potential for a negative bias, this looks like a bearish view for the next year.

Market-implied price return probabilities for ICLN for the 13.3-month period from now until January 20, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

The near-term market-implied outlook to January 2022 is neutral to slightly bearish. The outlook through 2022 to January of 2023 is bearish. The expected volatilities calculated from the near-term and longer-term options match, and the value is slightly higher than expected volatility for QQQ.

Summary

The outlook for clean energy is strong in the long term. Society is moving to reduce carbon emissions and solar and wind energy, along with other renewable sources, will be important parts of the production portfolio. The question of whether clean energy stocks, as a whole, look attractive today is a separate issue. In addition, the specific attributes of clean energy funds require some attention to detail. The stocks in ICLN have a range of attributes, from low-volatility utilities to highly-volatile solar hardware. Because of their different risk and return characteristics, the relative size of allocations are likely to change substantially over time.

The huge run up, and subsequent 32% drop, in ICLN over the past 12 months highlights the near-term sensitivity of clean energy stocks to politics. Looking forward, I am somewhat surprised that the expected future volatility is not higher.

The market-implied outlook for ICLN is generally neutral / slightly bearish in the near term, but looks more bearish over the next year. Considering the market-implied outlook, the political uncertainties with regard to government funding for clean energy, and the high turnover in the fund, I am assigning a neutral rating overall. I am discounting the more bearish tilt in the market-implied outlook to 2023 in part because the market-implied outlook for the energy sector has not worked out well so far this year.

Geoff has worked in quantitative finance for more than twenty years.Before entering finance, Geoff was a research scientist for NASA. Geoff holds a PhD in Atmospheric Science from the University of Colorado - Boulder and a BS in Physics from Georgia Tech.Neither Geoff Considine nor Quantext (Geoff's company) are investment advisors. Nothing in any commentary here on Seeking Alpha or elsewhere shall be regarded as advice.