Could This Hydrogen-Based ETF Be a 'No. 1' Pick?

It's no secret that, despite the global push for decarbonization, oil and gas companies have been outperforming in 2022. So, let's see how traditional alternative energy plays were faring and also take a look at what is slowly becoming a larger player in the non-carbon energy generation arena -- hydrogen and, specifically, the exchange-traded fund,  Defiance Next Gen Hydrogen ETF (HDRO) . Before anyone gets too excited, yes, I understand that the construction and maintenance of renewable generation plants come with their own carbon footprint, but let's save that discussion for another day.

Hydro and wind power have been around for centuries, and solar power has started to come into its own over the past few decades, although scientists are still trying to improve panel efficiency beyond 30%. One element that has been around literally since the formation of the universe, is in abundance, and has been used as a power source for years, is hydrogen. To provide exposure to this emerging area of electricity generation ETF issuer Defiance launched the Defiance Next Gen Hydrogen ETF in March 2021. The fund has a 30-basis point expense ratio, meaning that a shareholder with $1,000 invested over a calendar year would pay $3.00 in fees over that period.

Hydrogen Power 101

Believe it or not, the first hydrogen fuel cell was developed in 1839, but it wasn't until the 1950s that a commercially useful fuel cell was developed by engineer Francis Bacon, who happened to be a descendant of the "original" 16th-century Francis Bacon. Fuels cells continued to be researched and developed and have found uses like powering research complexes at Pfizer (PFE) , or as backup power sources for hospitals, hotels, and utility power plants. Hydrogen fuel cells are becoming increasingly deployed in commercial transportation (rail, trucking, buses), mostly due to work by Toyota Motor (TM)  and Mercedes Benz MBGYY .

The science of how fuel cells work is fairly straightforward, the process has no moving parts, and producing electricity generates only the byproducts of heat and water. Current fuel cells tend to use natural gas as the source so they do have a carbon footprint, but it is much smaller than other means of generating electricity. Don't forget, hydrogen is number 1 on the periodic table of elements, meaning it has just one proton and one electron, which also means that it is ridiculously small. Because of this, engineering tolerances for storing hydrogen are very high. In as much as there is a big difference between something being watertight and airtight hydrogen is notoriously difficult to store in gaseous form and is best stored in liquid form which it attains at -252.8°C.

While this technology has many benefits and huge potential, there are still a number of issues to work out, including storage and distribution. Still, there are a number of companies that are not just researching hydrogen fuel cells but producing them and most importantly for our purposes, generating revenue doing so.

HDRO

This fund tracks the BlueStar Hydrogen and NextGen Fuels Index. Looking through the methodology guide, the definition of "pure-play" companies sets the revenue hurdle at 50%. Regular readers know I'm looking for at least 75% - 80% revenue exposure for any kind of thematic, or targeted portfolio. The selection criteria also consider companies that currently don't have at least 50% exposure but have the "potential to generate 50% of revenue or play a significant role in the global hydrogen or fuel cell segment."

Looking through the holdings I see a lot of familiar names like Ballard Power Systems (BLDP) , Doosan Fuel Cell (DOOSF) , and Ceres Power Holding (CRPHY) . The fund invests in the local country shares of Doosan and Ceres but I've provided the ADR symbols to make things easier. There are also a few industrial gas providers like Linde (LIN) , Air Products and Chemicals (APD) , and South Korea-based Pungguk Ethanol (local ticker 023900). All in, if I remove names that aren't squarely focused on fuel cells, I'd have a portfolio of 18 of the current 25 companies. While I may gripe about thematic purity, at least all these names have recognizable ties to the strategy. If anything, it shows that Defiance and index provider MVIS are forward-thinking enough to bring this product to market ahead of the space getting saturated. I'll talk about whether or not they're too early next.

My Take

As you can see from the correlation table below the Hydrogen Fuel Cell market seems to be doing something different from other renewables and Oil. These correlation figures are based on daily moves between March 10, 2021, and Monday.

Source: Factset, All You Can ETF

The good news is that renewables seem to be more uncorrelated to oil lately. The bad news, as you can see from the year-to-date returns ending Monday, is that the reasons for that uncorrelation are not the ones investors want to experience.

Source: Factset, All You Can ETF

The longer-term chart echoes the year-to-date results with traditional renewables legging down and fuel cell technology lagging even further. Still, I'm a fan of this technology and would say that while widespread consumer adoption is still years away, the units that are in use currently are being put through their paces and functioning well. Despite the fund being down almost 70% since its launch in 2021, I would say at least put it on your watchlist if not start to nibble if you have any renewables exposure. Nothing core position worthy, but this technology isn't going away, so keep an eye on it.

At the time of publication, Abssy had no position in any security mentioned.