New hydrogen economy ETF launches – too late to back this theme?

The risk is that investors will gain exposure to companies that now trade at unsustainable valuations.

Alternative energy exchange-traded funds (ETFs) are all the rage right now. Most notably, the iShares Global Clean Energy ETF (LSE: INRG) has seen a surge of inflows, topped the most-bought ETF list on interactive investor and provided investors with roughly 100% returns over the past year.

One of the most interesting new launches in this sector is from Legal & General (L&G) - the L&G Hydrogen Economy UCITS ETF (LSE:HTWO), which is now available on interactive investor. This is a thematic ETF that intends to offer exposure to companies that are enabling the production of cheaper, clean forms of hydrogen, as well as those that are expected to play an integral role in the hydrogen economy.

What is hydrogen energy and why might it be important?

Hydrogen energy is a so-called clean fuel. Unlike oil and coal, when consumed it does not emit CO2. As a result, it is a seen as an environmentally friendly fuel source. As Bank of America Merill Lynch notes: “Hydrogen, the first, lightest and most abundant element in the universe, could supply our energy needs, fuel our cars, heat our homes, and help to fight climate change.”

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They note that while hydrogen technology has been around for decades, it has failed to be adopted by the mainstream. However, due to rapidly falling costs, advances in technology and increased commitment of government and businesses to become net carbon neutral, this could soon change.

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In particular, the bank says, hydrogen energy will help energy-intensive parts of the economy decarbonise. They note: “Hydrogen will have the greatest effect on sectors where decarbonisation with electricity from renewable energy is not possible.

“The industrial gas and chemicals sectors, should gain share of this energy supply and self-decarbonisation. Other sectors where electrification cannot be the answer, e.g. steel, heating, and transport, could transition.”

The ETF would be a way for investors to play this potentially growing sector.

Too concentrated?

If you look at the factsheet on the index, Solactive Hydrogen Economy Index, one thing that stands out is the size of the index’s weighting towards one company: FuelCell Energy (NASDAQ:FCEL). The company equalled around 17% of the index as of 18 February.

However, ETF investors need not worry about this. While the ETF is based on the Solactive index, the ETF uses an equal weighting methodology. L&G notes: “All constituents of the index are equally weighted within the index subject to certain liquidity based weight caps made to ensure that securities with lower liquidity are not overly represented in the index.” With seemingly 28 holdings, each stock should represent around 3.5% after being rebalanced.

On top of that, there is a cap. As LGIM notes: “On a monthly basis, the weight of each company is assessed and, if any of them exceed 15% of the index, the weights of all companies are adjusted so that they are again equally weighted within the index.”

This means that any one company will not dominate the ETF portfolio, as is often the risk with thematic ETFs. So Fuelcell Energy, or any single company, is not a huge weighting in the ETF.

Too much padding?

Peter Sleep, senior investment manager at Seven Investment Management, identifies one potential downside of the fund in ETF Stream. He points out that while some of the ETF’s holdings are direct hydrogen plays, the connection of others to the energy source is more tangential.

He notes: “The companies in the ETF break into two groups – the boring stocks and the theme stocks. The boring part you find in many thematic ETFs, padding them out.

“In this case companies such as Toyota (NYSE:TM), Daimler (XETRA:DAI), Cummins (NYSE:CMI), Hyundai Motor (LSE:HYUD) and Kyocera (NYSE:KYO). All large companies whose share price movement may relate to factors other than hydrogen.”

As a result, the ETF may be less related to hydrogen than investors expect. This so-called padding is a common problem with thematic ETFs.

Another potential downside of the ETF is that it has an ongoing charge of 0.49%. That’s relatively expensive for an ETF. However, there are still plenty of other specialist and niche ETFs charging more.

We’ve been here before

There has already been a lot of excitement surrounding hydrogen in markets already. For example, the above-mentioned FuelCell Energy has seen its share price appreciate by almost 1,000% over the past year. Bloom Energy (NYSE:BE), another holding in the ETF, has seen its share price double. You can read articles warning of a “hydrogen bubble” in titles such as Bloomberg or the Financial Times. 

The risk is that investors will gain exposure to companies that now trade at unsustainable valuations. Although the equal weighting of the ETFs helps protect against any single company which may be overvalued, the sector as a whole may be frothy.

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Even if the sector is not in a ‘bubble’ and facing imminent large price falls, it could still be the case that optimism is at its peak. The risk for investors is that it will not live up to expectations. 

And we have been here before with hydrogen. In the early 2000s, many cited hydrogen as likely to replace petrol for cars, with then-US President George W Bush expressing positive sentiment towards hydrogen and committing billions in investment. That, of course, amounted to little.

While the optimism around hydrogen may lead to more results this time, there is still the risk that the reality does not live up to the current hype, leaving investors with exposure to a basket of richly valued hydrogen stocks – alongside some car companies for padding.