Smart Sustainable Investing

Mark Hebner
Source: Index Funds Advisors Inc.
Mark Hebner

A lot of green has moved into green funds. That's the finding of the U.S. Social Investing Forum, which reports some $3.74 trillion in socially responsible investments last year, up 22 percent from in 2010.

While both public and private sectors have embraced environmentally sustainable investing in particular, the economic returns of 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 had a 9.7 percent annualized loss.

CalPERS' chief investment officer, seemingly disconnected from the imperative to invest for returns as well as values, called the debacle a "noble way to lose money." Perhaps the loss has caused CalPERS to rethink how it goes about investing (not to mention handling its PR), green or otherwise.

A recent article in Investment News said that CalPERS is considering a move to an all-passive portfolio. At the recent ECO:nomics conference, CalPERS Senior Portfolio Manager Anne Simpson, said, "The market, for all of its imperfections, horrors, ups and downs, and volatility is, over the long-term for an investor like us, the most effective way to capture economic returns."

(Read More: Where CalPERS & CalSTRS Are Putting Money)

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. CalPERS evidently learned this reality the hard way.

"The issue is not the need to address environmental issues, that's common sense," Simpson told the conference audience. "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," Simpson said. "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."

In other words, sustainable investments can't be just a nice idea but also must be sound.

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A handful of funds address sustainability—but too many satisfy emotionally, packing the proverbial sizzle, but no steak. Many such funds use a positive screening process, including only companies focused on specific, hot-button issues. Such funds can be costly to implement, underdiversified and risky because they are highly correlated and frequently buoyed by subsidies without a clear path to profitability.

The rules for sound investment need not surrender to social imperative with the understanding that the probability of a positive return is what distinguishes investment from charity—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 inclusion, add a high degree of diversification and establish a process that can be implemented in a relatively low-cost way.

Dimensional Fund Advisors (DFA) is a notable contributor to the sustainable mutual fund arena. The firm made its name through low-cost, diversified exposures with an emphasis on extracting more from the market's small and value corners.

DFA's sustainability funds pack a few thousand companies in 23 countries by implementing a patented process that eliminates, underweights or overweights based on a proprietary system applied across all sectors. The end result is a product that bears a strong resemblance to the market portfolio but allocated to substantially enhance sustainability. Both financial and environmental success can be achieved this way.

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.

Mark Hebner is the founder and president of Index Funds Advisors, a fee-only independent financial adviser in Irvine, Calif.

Disclosure: IFA is an independent fiduciary; Hebner and IFA have no conflicts of interests concerning their advice.

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