Why the consensus approach to energy investing is flawed

Why the consensus approach to energy investing is flawed

10 minute read

April 2024

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Investors have increasingly viewed energy through an either/or lens, taking a zero-sum view, and limiting their investments to traditional or alternative energy forms. This is a flawed approach.

KEY TAKEAWAYS

  • Most of today’s investment options take a zero-sum view of energy and limit their investment universes to either traditional or alternative energy investments. We think this is a flawed approach.
  • We believe a fundamental investment strategy that recognizes the reality of the world’s energy demands and blends traditional with alternative sources offers improved risk adjusted returns.
  • We expect winners and losers across both traditional and alternative energy. Consequently, we feel this sector is ripe for active management, as investors need to sidestep poor performing companies while zeroing in on secular winners.

Today’s energy landscape

Energy investors have been forced to take an either/or approach to investing, as the existing suite of investment strategies limits their investment choice to either traditional or alternative energy companies. We believe this is a flawed approach.

Such a binary view does not reflect the reality we see for the future of energy. Population and economic growth will drive increasing global energy consumption through 2040 and beyond, even after factoring in improving energy efficiency.

To meet this growing demand, the marketplace is expected to need all the reliable energy it can generate. We see significant growth coming from alternative energy, but the majority of the energy supply will still come from traditional. Because of this we believe the future of energy is really more of an “energy addition” story.

You can read more on this topic in our recently released paper: Changing the narrative from ‘energy transition’ to ‘energy addition.’

Flaws of current strategies

We believe there are inherent flaws in the existing strategies offering exposure to energy markets—namely, they tend to track only traditional energy or alternative energy benchmarks. These strategies are not adapting to the reality of the energy future.

For instance, the largest index to track traditional energy markets is the S&P Energy Select Sector Index. This index only offers exposure to companies focused on traditional energy, as determined by the Global Industry Classification Standard (GICS) for the sector, which is limited to energy equipment and services alongside oil, gas and consumable fuels. Further, we observe that the largest three stocks in the index make up nearly 50% of the total index by weight, and this concentration has increased from 37% in 2014. We have also seen the number of index constituents decline from 43 to 23 over the same period (Exhibit 1).

Put simply, the S&P Energy Select Sector Index is highly concentrated and only represents legacy traditional energy businesses. Though many traditional energy companies are investing capital in alternative technologies, the exposure to alternatives in the index is not representative of where we see the future going.

EXHIBIT 1
Largest traditional index dominated by three companies
Largest traditional index dominated by three companies

By comparison, many alternative energy markets are tracked by the S&P Global Clean Energy Index, which is used as a benchmark by many strategies that investors utilize to access the space. While we are optimistic about technological innovation and the significant growth ahead for alternative energy, we believe the flaw is that this universe is highly volatile and can often be dependent on factors such as technological success and government policy/tax incentives, which can be less predictable. Further, the future is not “all renewable” in our view of the “energy addition” world to come.

Alternative energy is the segment of the industry with the most robust growth outlook. However, not all technologies will be successful, as unit costs, consumer preferences and tax policies can have an outsized influence on outcomes. Passive indexes are by definition inclusive of a broad array of technologies, giving investors exposure not just to the best companies of the future, but also the structural losers. This can weigh substantially on returns.

We believe combining traditional forms of energy, such as crude oil and natural gas, with alternative energy forms, such as wind and solar, can create better investment outcomes. This is because a blended approach smooths returns as technological advancements and government policy ebb and flow (Exhibit 2).

More specifically, we project traditional resources will generate ~70% of global energy supply by market share by 2034, with alternatives making up the remaining ~30%. This acknowledges that traditional energy will play a key role for decades to come, while recognizing that alternative energy will also play a meaningful role and one that will grow with time.

With this in mind, we created a blended index comprising 70% traditional energy and 30% alternatives, which yielded more attractive absolute returns when compared with either individual strategy. Annualized volatility also fell when the two forms of energy were blended—the combination of which helped smooth returns.

We believe that making a dynamic allocation to both traditional and alternative energy will maximize opportunities across the energy value chain while providing exposure to the ongoing evolution of energy markets.

EXHIBIT 2
Historically higher returns, lower risk

Blended approach is poised to provide strong returns with less risk

Historically higher returns, lower risk

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We believe investors need to redefine what the energy market is—away from a zero-sum ideology to a broader universe. A high-conviction, actively managed approach that includes both traditional and alternative companies offers broader exposure and more accurately represents what the future of energy will look like, in our view.

The disparity between the winners and losers within energy indexes is great, reflecting the rapidly evolving industry, and also the relative uncertainty in energy investing. A closer look at the indexes illustrates this.

The average return of the top 10 holdings within the ETF that tracks the S&P Global Clean Energy Index was +311% over the five-year period ending December 31, 2023, while the average return of the bottom 10 holdings was -83%.

Within the ETF that tracks the S&P Energy Select Sector Index, the average return of the top 10 holdings was +141% over the same five-year period, while the average return of the bottom 10 holdings was -31%.

By investing in an active strategy, investors can be better positioned, in our view, to sidestep poorly performing companies.

We believe an investment approach that pairs traditional and alternative energy through an active strategy will create superior investment outcomes. Focusing only on traditional or alternative fails to provide an accurate representation of current and future energy markets.

Winners and losers across the energy landscape

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