Environmental Investing: Is the Grass Always Greener?

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Hybrid cars, organic foods, energy-saving light bulbs - all of these "green" products have gained increasing attention and popularity over the past decade. So it is no surprise that Green Investing is the latest trend on Wall Street. Though some believe this is just another fad, many are convinced that green investing is a trend that is here to stay.

Socially Responsible Investing

Green Investing is similar to Socially Responsible Investing (SRI) in that both are strategies driven by investors' desire to achieve financial return while maximizing social good. Socially Responsible Investing has a broader focus - companies that are considered for investment are those that have a positive impact on society, whether in regard to the environment or otherwise. Conversely, companies that have a perceived negative impact on society, such as businesses that produce alcohol, tobacco or weapons, are eliminated from investment selection. Currently, total U.S. investment in SRI strategies adds up to more than $2 trillion in assets, including mutual funds and pension plans. That represents one out of every eight dollars of professionally managed money in the U.S.¹ In particular, government pension plans and university endowments are increasingly subject to pressure by activist groups or students and alumni to adopt or enhance SRI screening, so investment in SRI strategies is expected to grow.

Why Go Green?

Green Investing is a subset of SRI that concentrates on investing in companies or technologies that have a positive effect on the environment, such as businesses making an effort to reduce their greenhouse emissions, or those looking for renewable energy sources. For example, clean technology or "cleantech" companies are those that work to improve operations, performance, productivity and efficiency while lowering their energy consumption, inputs, waste or pollution.

Investors are placing money into green companies for a combination of two reasons: to fulfill perceived ethical responsibilities by helping to improve the environment, and to ride the next big wave in the stock market. But whether you are an individual or institutional investor, the key to making a profit is to choose the right instruments in which to invest.

The growth of green mutual funds and exchange traded funds (ETFs) is on the rise. Investors who are more risk-averse should look to invest in one of these types of funds, which typically provide a good amount of diversification. Green mutual funds invest in a variety of companies, and some will invest in various green industries, such as solar, wind, bio-fuels, or recycling. ETFs track indices and also offer instant diversification. Finally, there are many funds that invest in international green companies, thereby providing global diversification.

Those investors willing and able to take on more risk can go for a "pure play" strategy - investing directly in green companies. The definition of a green company is subjective, however. A company may improve its manufacturing plants by incorporating solar power, thereby reducing greenhouse emissions, but if that company produces gas-guzzling SUVs, some may not consider it environmentally friendly.

Greener Than You Think

Green companies typically arouse thoughts of companies whose main business line is to create products or technologies that will help improve the environment. Examples include companies looking for renewable energy sources (solar, wind, water, etc.) or those producing organic foods that do not use pesticides. But there are many other types of companies going green that could potentially pass an investor's screening process. Wal-Mart, for example, is a chain of large discount stores and the largest private electricity user in the U.S. - not your typical green company. However, in 2007, it unveiled an environmental plan that seeks to conserve more energy in stores, make trucks more efficient, and push suppliers to reduce packaging waste. Specifically, it plans to cut energy use at its more than 7,000 stores worldwide by 30% and cut greenhouse gas emissions at existing stores by 20% in 7 years.

Another atypical green industry is automobiles. Toyota and Honda have both jumped onto the green bandwagon in part to capitalize on the growing consumer demand for hybrids. This is an instance where top-line growth may be more of an incentive to go green than environmental responsibility. In 2000, only 9,300 hybrid cars were sold. In 2006, approximately 200,000 were sold, and half of them were made by Toyota.

It's Not Easy Being Green

As with other investment strategies, Green Investing is not without risks. First, since many green companies are relatively new, they face the same risks as most small-cap companies, including price volatility and illiquidity. Second, investors of green mutual funds need to be aware of relatively high trading costs and fees. Green ETFs also can have relatively high expense ratios that can be as high as 75 basis points. Finally, government changes to environmental regulation could affect how companies are allowed to operate, potentially drastically affecting the bottom line.

Does Green Investing = Green ($$$)?

Investment results for green funds have been mixed. Some funds have out-performed the market, such as the PowerShares WilderHill Clean Energy (PBW), the PowerShares Cleantech (PZD), and the First Trust NASDAQ Clean Edge ETF (QCLN) funds. Others, such as the iShares Select Social (KLD) fund, have closely tracked the market. Below are 1-year charts for these funds compared to the S&P 500.

Performance for Various Green Funds vs. the S&P 500 (March 1, 2007 - February 29, 2008) (Click to enlarge)

Conclusion

In a May 2007 interview for Accredited Investor magazine, Hillary Kramer, founder of GreenTech Research LLC, described Environmental Investing as "the very first inning of a growing and developing space." As with any type of product or service, there are many companies and investors that will prosper while there are others that will suffer losses. But clearly, environmental concerns are not going away; on the contrary, initiatives to "save the planet" are on the rise. Green investors can attempt to profit from this movement, and perhaps even sleep better at night knowing they are doing their part.

¹GreenMoneyJournal.com ("Retirement Billions can be Harnessed to Green the Economy" by Paul Clarke, Winter 2007-08).

Performance and Risk of Broader SRI Mandates JPMorgan Investment Analytics & Consulting constructed a 4-factor regression model focusing on the returns of 30 Socially Responsible Investing (SRI) mutual funds. Unlike the results of Green Investing, the results for the broader SRI group prove unfavorable over a 5-year period. The SRI group underperformed the S&P 500 by approximately 150 basis points. The risk of the SRI funds, as measured by alpha standard deviation, was significantly higher vs. the S&P 500. (click to enlarge)