KGHG Q4 Commentary: Continued Outperformance, Government Policy Driving Growth
The KraneShares Global Carbon Transformation ETF (Ticker: KGHG) had a strong fourth quarter, beating the rising market after outperforming in a falling market in the third quarter.
For the period, the net asset value of the portfolio generated a return (gross of fees) of +13.5%, which compared favorably to the MSCI World Index’s total return of +9.9%. The fund’s investment strategy is not executed with a specific benchmark in mind; however, the global equity reference provides context. For the same period, the S&P 500 total return was +7.6%, and the Nasdaq Composite was -0.8%.1
For KGHG standard performance, top 10 holdings, risks, and other fund information, please click here.
In what is recognized now as the most challenging year for markets since the financial crisis, both stocks and bonds lost value. The Federal Reserve raised rates twice in the fourth quarter, bringing the total number of rate increases in 2022 to seven and the Federal Funds rate to 4.5% (from 25 bps at the beginning of the year).2 The serial interest rate increases had a dampening effect on consumption, and both stock and bond indices posted calendar year losses for the first time since 1969.3 With its exposure to the secular growth theme of decarbonization, the fund provided relative defensiveness during the period and offers high visibility growth going forward. Since its March 15th inception, the fund’s net asset value implies gross returns of -4.0% versus -7.5% for the MSCI World Index, -8.7% for the S&P 500, and -18.6% for the Nasdaq Composite.4
As in the prior period, equity markets rallied intra-quarter and then gave back a portion of their gains. A notable difference in Q4 was the behavior of the US dollar, which peaked in late September and sold off more than 9% to its year-end level. As more than 70% of the fund’s investments are in non-USD-denominated securities,5 this reversal removed what had previously been a headwind facing the unhedged, globally invested fund and enhanced the return realized on its foreign equity positions. At the end of the quarter, the dollar remained about 4% higher than at the time of the fund’s launch, but the distortion created by the foreign exchange effect since launch has now been materially diminished. The future direction of the dollar will be a function of relative monetary policy action in the US versus foreign markets, but, for now, after a more than 25% move in the currency since early 2021, the sustained strength in the US dollar appears to have abated.
To reiterate our mission, KGHG seeks to invest in companies that are transitioning to lower-emission business models, and we believe that this strategy has the potential to create both financial and social value. Our focus is not on absolute corporate emission levels but on the rate of change. As such, the fund frequently invests in companies with a high carbon footprint that are actively investing in the energy transition. Transitioning to lower emission business models offers the potential for superior growth, market share gain, lower cost of capital, margin expansion, and higher valuations than for those companies in the same industries with high emission profiles. As such, there is a valuation arbitrage to be captured as companies migrate from higher to lower emissions. Moreover, management teams are financially incentivized to pursue this strategy as it creates shareholder value. As investor recognition of 'emission improvement' as a source of financial alpha grows, we believe this trend will intensify and the cycle to return generation will shorten.
At quarter end, the portfolio held 42 companies based in 17 countries. The majority of the companies owned in the fund conduct business multi-regionally, and as such, the location of their headquarters or the market in which they are listed provides only a partial picture of their operations. Among the criteria considered in selecting securities for the portfolio are the exposure of the company to jurisdictions with policy in place that is supportive of the energy transition. Corporate spending on energy transition is influenced by the presence of both negative and positive government policy mechanisms. Negative mechanisms (such as carbon taxes and emission quotas) can raise the cost of legacy business activities, impairing their profitability, while positive mechanisms (such as stimuli and tax incentives) can enhance the economics of low emission solutions, speeding their adoption.
As noted previously, in the third quarter, the passage of the US Inflation Reduction Act (IRA) provided transformational policy support for a wide range of activities related to the energy transition. The magnitude of the support that the IRA provides for companies operating in the United States is so great that the European Union is scrambling to come up with a policy response to provide a similar investment incentive. This emerging global ‘arms race’ of government policy support is uniquely beneficial to the group of companies that have the skills and capabilities to aid the energy transition. The leaders in this area are the focus of KGHG.
During the quarter, the fund added a position in NorskHydro (NHY). The company is one of the world’s largest aluminum producers, operating in 40 countries.6 Our investment decision has multiple drivers, including increasing demand for aluminum, NHY’s uniquely large renewable power generating base, its ability to command green premiums for its products, and its specific strategies around decarbonization.
As with copper, aluminum demand is expected to grow with the energy transition. Copper is prized for its conductivity, and aluminum is valued for its strength-to-weight ratio. Automobiles increasingly have larger aluminum content at the expense of steel as weight saving drives overall efficiency. NorskHydro is uniquely positioned in the global aluminum industry both for its low position on the cost curve (at the 17th percentile) and also for its low-carbon production process.7 Aluminum smelters are highly energy intensive, and with its substantial hydro assets, Norsk meets 50% of its own power requirements.8 This results in not only a lower-carbon end-product, which is increasingly important to customers but also indemnification from both volatile energy input costs and rising carbon taxes.
During the quarter, the fund generated positive attribution in each of its subsector allocations, with energy, materials, and utilities being strong contributors. Oil service company Baker Hughes, which fell 27% in Q3 and was a notable negative contributor for that period, recovered to close above its Q2 high. It was the largest security contributor, generating 118 bps of attribution. Baker has traditionally been considered a cyclical stock, with its business levered to oil and gas industry spending. In addition to benefitting from increasing spending on conventional energy and liquified natural gas (LNG), the company is positioned for substantial structural growth in new energy as its expertise in handling liquids and gases will see increasing demand in areas such as hydrogen and carbon capture, utilisation and storage (CCUS).
US utility AES Corporation, which is aggressively transitioning to a greener portfolio, contributed 105 bps, and French oil supermajor TotalEnergies 100 bps. Other notable contributors were French electrical equipment distributor Rexel (+78 bps), Norwegian aluminum producer NorskHydro (+71 bps), and German utility group RWE (+64 bps).
A notable detractor during the quarter was Chart Industries, with a negative impact of 115 bps. In November, Chart announced the acquisition of Howden, a complementary portfolio of air and gas handling products that materially expands Chart’s offering in its core product areas. The acquisition was not well received by shareholders, who questioned the price paid (12.0 x EBITDA) and the ability of Chart to extract promised synergies. We have significant respect for Chart’s CEO, Jill Evanko, and believe that the combined company is well-positioned for structural growth as the energy transition advances. We will keep a close eye on management’s ability to deliver on their acquisition commitments.
We believe our thesis of owning ‘greening’ companies is extremely well-positioned in this slowing environment. Decarbonization activity is driven and supported by government policy and addresses climate goals, the need for energy security, and economic development objectives. We are appreciative of your confidence.
- Data from Bloomberg, retrieved 12/30/2022.
- Data from Bloomberg, “Federal Funds Target Rate (FDTR Index),” retrieved 12/30/2022.
- CNBC, “This is the worst year for stock and bond investors since 1969—here’s what to do with your money,” Oct 19, 2022.
- Data from Bloomberg retrieved 12/30/2022.
- Data from Bloomberg, “KGHG Portfolio Allocation,” retrieved 12/30/2022.
- S&P Global Ratings, “Norsk Hydro ASA,” Oct. 27, 2022
- Hydro, “Unique Position in a New Reality,” Capital Markets Day 2022
- Goldman Sachs, “Norsk Hydro (NHY.OL): Key takeaways from 2022 Capital Markets Day,” Dec. 15, 2022.