Thematic ETF Shortcomings: A Mighty Wind?

I've been getting a lot of user feedback regarding several alternative-energy and infrastructure-related funds, and it's easy to see why. Several of these themes, such as wind and solar power, or the highly anticipated global infrastructure build-out over the next decade, have intriguing merits. What irks me, though, is the insistence of the representative ETFs issued over the past year that have large allocations of utility investments.

Take the two wind ETFs that have surfaced over the past two months: First Trust Global Wind Energy (FAN) and PowerShares Global Wind Energy (PWND). Let me start by saying that both of these funds give investors significant exposure to the biggest names in wind power equipment producers, a feat that is not easily accomplished by U.S. investors because most of these firms are based in Europe and lack American depository receipt (ADR) issuances.

Firms like Vestas, Gamesa, and REPower dominate the market, and companies such as Japan Wind Development, Clipper Windpower, and Nordex earn significant profits from the proliferation of wind power. If you are truly bullish on wind power specifically, you want to own these names, and both of the aforementioned ETFs give retail investors a means to that end.

But for other underlying holdings, such as  Royal Dutch Shell (RDS.A),  E.ON (EONGY),  BP (BP), RWE (RWEOY), and  NRG (NRG), wind power is about as important to their overall returns as frog legs are to a balanced diet. In fact, a $1 change in the long-term average price of natural gas will have more impact on these companies than will doubling their wind power capacity.

I'm not saying that buying either of these wind ETFs is a bad idea. I'd just rather see the funds focus exclusively on stocks with fortunes that will most directly be tied to the success or failure of the investment theme itself. Buying these ETFs will increase your allocation to utilities and energy stocks with fortunes that are not driven by the success of wind power. Inclusion of the aforementioned stocks in the underlying indexes merely lowers volatility and provides large and highly liquid stocks in which the ETFs can invest. If you are using these funds as noncore satellite holdings to complement a diversified base portfolio, you will simply be getting some stock overlap.

Wind ETFs are not the only culprits. Solar funds like Market Vectors Solar Energy (KWT) and Claymore/MAC Global Solar Energy (TAN) are also guilty. Furthermore, these solar funds have large allocations of domestically traded stocks, so the ETFs themselves do not materially increase market access for individual investors; buying the stocks directly is not that hard.

The same can be said for the few infrastructure funds on the market. While iShares S&P Global Infrastructure (IGF) and SPDR FTSE/Macquarie Global Infrastructure 100 (GII) do in fact focus on companies that develop and operate basic infrastructure, they have a heavy focus on utilities. An investor seeking a stake in large-scale global infrastructure development could start by allocating some capital to either of these funds, but I believe that most of the economic profits that would be produced from development would accrue to the upstream commodity producers and the engineering, procurement, and construction companies that are further up the value stream.

Therefore, an investor seeking to profit from the global infrastructure build-out should additionally consider an ETF with basic materials exposure. I think that iShares S&P Global Materials (MXI) fits the bill. Its broad exposure to materials should benefit from the long-term global build-out and round out your exposure.

Two supporting candidates I reviewed but in which I found shortcomings are the  Materials Select SPDR (XLB) and  iShares DJ US Basic Materials (IYM) funds. While these funds have a number of industrial companies that would benefit greatly, both also have  Monsanto  as their largest holding, at more than 15% and 11%, respectively. Monsanto is a great company, but it doesn't really benefit from infrastructure.

Going forward, I'd like to see all of the thematic ETFs live up to their nomenclature by avoiding the inclusion of loosely affiliated stocks in their indexes. Issuers take note: Please leave the rest of the portfolio diversification choices up to the capable financial advisors and savvy investors who would purchase these specialized funds.