Smart Sustainable Investing

A lot of green has moved into in green funds. This is the finding of the U.S. Social Investing Forum whose 2012 report reveals some $3.74 trillion is invested in socially responsible investments — up 22% in 2012.

While both public and private sectors have emotionally embraced, in particular, environmentally sustainable investing, the economic returns produced from such strategies have largely failed to justify their appeal.

One highly visible example is CalPERS, the nation's largest pension fund. The $259 billion pension made a $900 million investment in a green energy fund that recently produced a 9.7% annualized loss. Seemingly disconnected from the imperative to invest for returns as well as values, CalPERS' Chief Investment Officer called the debacle a "noble way to lose money."

Perhaps the loss has caused CalPERS to rethink how they go about their investments (not to mention their PR), green or otherwise.

A March 19, 2013 article in Investment News cites that CalPERS is considering a move to an all-passive portfolio. That sentiment is echoed quite strongly by CalPERS' Senior Portfolio Manager, Anne Simpson. "The market, for all of its imperfections, horrors and ups and downs and volatility is, over the long-term for an investor like us, the most effective way to capture economic returns," Simpson told an audience at the recent ECO:nomics conference.

Indeed, the market rewards investors who commit capital to companies that, in turn, deliver profits. For this reason, companies failing to produce profits suffer the derision of willing investors. This cruel reality was seemingly learned the hard way for CalPERS.

"The issue is not the need to address environmental issues, that's common sense… look at the disappointments for all concerned with the solar industry in Spain. The whole investment proposition is set up, and there are big pension funds invested, putting up capital, building up a solar industry which is relying on a certain tariff being paid by the Spanish government. Guess what? Things fall apart in Europe with the debt crisis and it's slash and burn on everything, including that tariff--and suddenly, that deal is uneconomic. So we've got to get to the point where we are helping these markets function efficiently, but without the artificial prop of ill-thought-through or unreliable subsidy." Simpson stated.

In other words, sound sustainable investments are a nice idea, but they must, first and foremost, be sound investments (see this video). 

There are a handful of funds that address sustainability, with just too many satisfying an emotional pull, packing the proverbial sizzle, but no steak. Many such funds incorporate a positive screening process, including only companies focused on specific hot-button issues. Such funds can be costly to implement, under-diversified, and quite risky because they are highly correlated and frequently buoyed by subsidy without a clear path to profitability.

The rules for sound investment need not surrender to social imperative, understanding too well that the probability of a positive expected return is what distinguishes investment from charity — with the latter undermining the process and its very sustainability.

So, how does one fashion a financially sustainable sustainability strategy? Begin with a sound investment selection process, or rules of construction for company inclusion; add a high degree of diversification, and establish a process that can be implemented in a relatively low-cost way.

A notable contributor to the sustainability mutual fund arena is Dimensional Fund Advisors (DFA). This company made its name through low-cost, diversified exposures to the markets with an emphasis on extracting a deeper slice from the small and value corners of the market. DFA's Sustainability funds pack a few thousand companies among 23 countries by implementing a patented process that eliminates, underweights or overweights companies based on a proprietary ratings system applied across all sectors. The end result is a product that bears a strong resemblance to the market portfolio, but more prudently allocated to substantially enhance sustainability. In this way, financial and environmental success can be achieved.

Investors who construct risk-appropriate portfolios of funds that include the steak are compelling stewards of a meaningful and ongoing shift in how firms manage climate change, pollution, resource consumption, and more — a sustainability effort that is truly sustainable.