Investors Should Prepare as Climate Policies Gear Up. There Are a Lot of Choices.

A burgeoning number of climate-focused funds could help achieve that goal, but navigating the landscape can be challenging. The climate funds offer a diverse mix of strategies, and new ones are being launched every day.

According to Morningstar, there are now 636 climate-related funds around the globe, and about 30% of them—a record high—were launched this year. Assets in climate funds have increased by 50% in 2021, to some $275 billion. The U.S. accounts for roughly 10% of the market, roughly the same as China but far behind Europe’s 78%.

These funds generally come in a handful of types. Some are well diversified and aim to mitigate climate-related risks by excluding fossil-fuel names or tilting toward stocks with a lower carbon footprints or better preparation for an energy transition. These funds can be used as a core portfolio allocation, replacing current investments that don’t consider climate risks.

For example, the $1.3 billion iShares MSCI ACWI Low Carbon Target exchange-traded fund (ticker: CRBN) holds more than 1,300 lower-carbon-emitting stocks within the MSCI ACWI index, or about 84% of the index’s total market capitalization.

Although many have criticized sustainable funds for charging higher fees, the ETF, with an expense ratio of 0.20%, is actually cheaper than its nongreen version, the $17.2 billion ETF (ACWI), which charges 0.32%. The low-carbon fund also slightly outperformed the nongreen version in the past one-, three-, and five-year periods.

For those who want to profit from climate-related opportunities, some funds specifically invest in companies that help facilitate low-carbon and clean-energy initiatives, often in the industrial, utility, and technology sectors. These funds are often concentrated and tilt toward smaller-cap names. They can be added to a portfolio on top of the core allocation, making a conscious bet on the potential beneficiaries of a greener economy.

But investors need to be patient and hold a long-term view: After an extended bull run in the past two years, many clean-energy stocks are already expensive. The $1.1 billion ALPS Clean Energy ETF (ACES), for example, holds about 40 stocks in solar, wind, electric vehicle, smart grid, and related categories. The fund soared 50% in 2019 and 140% 2020, but has been sliding since reaching a February peak. It now trades at 44 times earnings and has gained just 1.4% year to date.

Investors might be better off with actively managed funds that are more flexible in stock selection and can seek still-underpriced corners of the market. The $802 million Fidelity Environment and Alternative Energy fund (FSLEX), for example, not only owns highflying names like Tesla (TSLA) but also fairly priced companies in pollution control, water infrastructure, waste and recycling technologies, and other environmental support services. The fund is up 32% this year and trades at 29 times earnings.

For income seekers, the Invesco MSCI Green Building ETF (GBLD), launched just a few months ago, holds real estate investment trusts that generate at least half of their revenue from green-certified properties that have superior energy efficiency and less environmental impact than conventional assets. These properties can usually get higher rents, says Rene Reyna, Invesco’s head of thematic strategy. “You are basically getting a premium,” he says.

REITs in the fund’s underlying index yielded 3.7% over the past 12 months, while the iShares Global REIT ETF (REET) yielded 2.2%.

Another way to profit from the net-zero push is to invest in capped allowances linked to carbon emissions. Since policy makers are expected to lower the caps over a number of years, prices of these “carbon credits” should rise and provide an incentive for companies to reduce their emissions.

The $1.1 billion KraneShares Global Carbon ETF (KRBN) holds the most liquid carbon-credit futures contracts on major European and U.S. markets, and has already risen more than 100% since launching 15 months ago. The ETF now reflects about $42 per ton of carbon emissions on those markets. Still, the current price is far below the level needed to accelerate a low-carbon transition fast enough. The Organization for Economic Cooperation and Development estimates that $147 per ton is needed by 2030 if the world hopes to hit net-zero by 2050.

That means more-aggressive policies are likely coming. At COP26, a number of leaders called for a global framework to price pollution. They want a larger share of carbon emissions to be covered, and for wealthier countries to pay a greater share of the costs.

Of course, economic cycles, weather conditions, and prices of other energy commodities also affect the carbon market’s short-term movements.As Europe saw natural-gas prices soar in recent months due to supply crunches, some energy producers switched to cheaper but dirtier coal, which has fueled demand for carbon-emission allowances and prices.

When that demand wanes, carbon prices might temporarily pull back, but the KraneShares Global Carbon ETF’s long-term uptrend should remain.

Write to Evie Liu at [email protected]