YieldCos are the latest way for investors to cash in on rising renewable energy demand and adoption. Structured as “pass-through” entities, the YieldCos offer investors and sponsoring utilities a way to earn some pretty hefty dividends. The new Global X YieldCo Index ETF YLCO makes adding them a snap.
Inside YLCO's Strategy
ETF issuer Global X has been pretty successful at bringing many innovative and first-mover funds to the marketplace. The newly launched Global X YieldCo Index ETF YLCO is no exception. YieldCos represent a way to play the demand/end-user side of many renewable energy assets. Basically, a utility will place various solar facilities, wind farms, and other generation assets into a separate spun-out firm. Various tax and deprecation credits allow the YieldCo to pay virtually no tax and pass much of its cash flow back to investors and sponsoring firms. They are very similar to how master limited partnerships are structured. Like MLPs, investors are treated to large dividends.
YLCO will track the INDXX Global YieldCo Index, which is an adjusted market-cap weighted index designed to provide access to globally listed securities that are categorized as YieldCos. INDXX defines these stocks as companies that are formed to own operating assets that produce defined cash flows. The index will cap the number of firms in the index at 20 and use a staggered market-cap weighting to determine its holdings. The index will rebalance semi-annually.
Currently the ETF holds 23 different YieldCos. As expected, utilities make up the bulk of the fund at nearly 69% of assets. And while it might seem odd that “miscellaneous” is the second-largest sector weight at 18%, the reason is that some YieldCos are structured as MLPs. That causes confusion when trying to classify them. Technology rounds out the rest of the fund.
And since YieldCos are very much a North American invention, YLCO is really a bet on our continent. The United States makes up the vast bulk of the fund, at 47% of its holdings, while Canada clocks in at 15.75%. As a hot bed of renewable energy activity, Spain comes in third at 11%. The remaining two nations, Bermuda and Guernsey, shouldn’t be confused as real international holdings. Their lower tax rates make the nations prime spots for firms to be incorporated.
Considerations for YLCO
Given the sector on which YLCO is trying capitalize, there are several points that investors must consider before moving their hard earned cash into the ETF.
We can start with the fund’s concentration risk. YLCO only holds about 20 or so stocks at any given time. Such few holdings may not be enough diversification to overcome single stock biases or issues. To make matters worse, many of the fund’s top holdings constitute large percentages of its small asset base. For example, Brookfield Renewable Energy Partners LP (BEP) makes up 11% of the ETF, while TerraForm Power, Inc. (TERP) makes up about 8% (as of 8/27/2015). If one of these stocks has a bad day, it will certainly weigh on YLCO’s performance. The diversification is there, but perhaps not enough.
One of the hallmarks of investing in YieldCos are their large dividends and cash flows. A high yield is great, unless you’re about to enter a rising interest rate environment like we are now. As yields on boring and uber-safe treasury securities rise, investors typically abandon riskier higher yielding assets. YieldCos certainly fit that bill. Shares of YLCO will fall initially as the Fed begins to raise rates. Even the fear of that scenario has already hurt the recent performance of many high-yielding sectors, including utilities.
As for that performance, we have no idea how the YieldCos will do over a full business and market cycle. YieldCo’s high-yielding siblings, real estate investment trusts (REITs), MLPs, and business development companies (BDCs), have all been around for ages. At this point, you can pretty much predict and react to how they will do over the course of a full market cycle. With the oldest YieldCos only debuting in 2014, it’s still anybody’s guess.
How to Use YLCO in a Portfolio
The high-yield nature of YLCO is a prime way to add some spice to an income portfolio. Despite some of the marketing literature, it’s still a pretty volatile fund, and as such, it won’t replace your bread-and-butter bonds. But it could be used as way to add extra some “oomph”, boosting the yield of a portfolio. Additionally, YieldCos can be thought of as a total return element: dividends plus share price appreciation. Like MLPs and REITs, the best way to use YLCO would be harvesting gains after years of dividend reinvestment.
The Bottom Line
The new Global X YieldCo Index ETF is a very unique play on renewable energy growth and adoption. The ETF provides a great way for investors to bet on the growing asset class and add some extra income/yield to their portfolios. Just bear in mind some of the ETF’s issues before pulling the trigger.