Single sector alternative energy ETFs are always volatile

Most investors consider index funds and ETFs as great tools for cost effective diversification of investment portfolio. This is certainly true for ETFs based on broad indices. Single sector indices and ETFs are considerably more volatile and riskier investments.

Alternative energy ETFs are a good example for this. Usually they track rather narrow indices consisting of only a few dozen companies. As the number of the underlying securities is rather low compared with for example S&P 500, the volatility is bound to be higher than the volatility of a broad index.

Furthermore, the returns of securities included in a sector index are usually highly correlated with each other. Because of this the alternative energy ETFs do not provide the portfolio with as much diversification as ETFs based on a broad index would do.

Of course, alternative energy indices and ETFs help the investor to significantly reduce the risk a specific company adds to the investment portfolio. Thus they help to diversify the company specific risk. They do not, however, provide any hedge against policy changes or against the impact of changes in e.g. energy price that tend to have an effect on the whole sector.

Paper with numbersMost investors who buy an alternative energy ETF tend to be bullish on the sector. If the market behaves counter to the expectations the losses can be very steep.

On the other hand, you might use alternative energy ETFs or other sector ETFs just in order to diversify your portfolio. Any specific sector might not have that high correlation with the general development of stock markets. Thus a small investment in a volatile but potentially lucrative market sector might in fact reduce the total volatility of your portfolio.

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