by Adam Ozimek

The size of European and Asian country’s green energy industries and the generous government subsidies and industrial policy they thrive on is looked at jealously by many American commentators who wonder “why not us?”.

Diversification is widely accepted as a nearly costless way to reduce the risk of a portfolio. Diversification averages out the idiosyncratic risk that arises from unexpected events at particular companies, but it does nothing to remove market risk. When the market falls, nearly all stocks fall with it. The benefits of diversification from each new stock added to a portfolio are smaller than the diversification benefits of the prior one, but the costs of adding each new stock are nearly constant: transaction costs, and the cost of your time to do the research you need to decide this is the stock you want.

Most investors try to get the best of both worlds by buying mutual funds or exchange traded funds. I discussed the relative merits of these approaches in Part I of this series on Green Investing for Beginners. Green energy mutual funds are substantially more expensive than either green energy Exchange Traded Funds [ETFs] or stocks. The ETFs are much better than the mutual funds when it comes to costs, but brokerage commissions have fallen so low that stocks often have lower costs after just a few years.

Most of us have come to assume that ETFs do a pretty good job of tracking their indexes, and we do not worry much about it. Maybe we should.

According to The Wall Street Journal, a recent study from Morgan Stanley shows that in 2009 ETFs more than doubled their tracking error rates over 2008, to an average miss of 1.25% versus 0.52% a year earlier. While the average error doubled, it is still so small that it made us wonder if it could possibly be that small for alternative energy ETFs.