Going Beyond the Hype of Green Investing

It seems these days that everywhere we look we're being asked to "go green." With all the attention surrounding Al Gore's documentary, "An Inconvenient Truth," and his new Nobel Prize, it's not surprising we're seeing a growing number of mutual funds and ETFs touting green credentials. As a result, we'd like to assist investors in identifying the strongest investment options among this growing fund and ETF niche.

The Latest Green Wave
This isn't the first time we've seen green. Since the oil scare of the 1970s, we've seen environmentally oriented mutual funds pop up from time to time. But a number of funds ended up closing up shop due to light investor interest or lackluster performance. Even so, there is a growing consensus among scientists, policy makers, and investment pros that alternative forms of energy will be necessary to meet global demand in coming decades. And the regulatory environment around climate change will likely have a significant impact on businesses in multiple industries. As a result, a broad range of companies, from fledgling startups to multinational corporations to a host of new consulting firms, are examining how climate-related factors may have an impact on their bottom lines. Similarly, heavyweight institutional investors such as pension funds, investment banks, and insurance companies are working together to navigate the transition to a greener world. That combination of factors has us thinking green investing could be more than a passing fad.

What Does Green Mean?
We've seen several approaches to green investing. We call one style the "best-in-breed" approach, in which the idea is to invest in companies with industry-leading environmental track records. That tack guides Green Century Equity (GCEQX), which currently owns  Proctor & Gamble (PG) and  3M Company (MMM) because its managers consider them to be among the greenest operators in their industries. We also see funds like  Winslow Green Growth  that invest in "clean" companies, meaning those that have no negative environmental impact. Lastly, a number of funds invest in "environmentally proactive" firms that produce goods or services linked to green initiatives like alternative energy, energy efficiency, emissions reduction, water distribution, and agriculture. Such options include the Guinness Atkinson Alternative Energy Fund (GAAEX) and the ETF  PowerShares WilderHill Clean Energy (PBW). Some funds blend several styles, such as Spectra Green (SPEGX) and Portfolio 21 (PORTX).

Investors need to look under the hood and decide for themselves which green strategy they'd prefer. Socially conscious investors may be surprised that not all green funds fit the bill (because they may invest in nuclear power companies, for example). Others seeking the biggest bang for their buck might favor a fund in which management tends to invest strictly where it sees the most attractive growth opportunities.

Finding Winning Green Funds
To sort through green investing options we'd first look for clear communication from the fund's management detailing its green definition and its investment universe. Some green funds may lean heavily on large-cap or small-cap stocks. Some invest domestically and some globally, so they can also alter a portfolio's geographic exposure. We'd home in on those that draw on several green investing styles because they're apt to have greater flexibility in selecting winning stocks in a variety of market conditions.

Manager experience, important in any mutual fund, is especially pertinent in green investing. Many companies in green industries such as solar, wind, and biofuels are early stage firms and thus carry the risks common to all small-cap growth stocks. They can also be subject to the same cyclical pressures that buffet traditional energy stocks. As a result, we'd favor management teams that have been around the block a few times and are familiar with the pitfalls of small-cap stocks and the volatile energy sector. We'd also prefer to see teams with deep research resources, in part because government regulation (which varies by country and is constantly evolving) can have a big impact on green companies.

Two funds that meet our criteria thus far are the Winslow fund mentioned above and Calvert Global Alternative Energy (CGAEX). Although we cover a number of green funds, we're likely to take a closer look at additional green options in future articles.

Don't Overlook the Risks. 
Did we mention 'don't overlook the risks'? In addition to the challenges discussed above, some green funds present risks of their own. Many green industries are young and likely to experience growing pains. For example, relevant governmental regulation or subsidies can change quickly, either making or breaking a one-product firm's fortunes. And, smaller-cap green stocks can sometimes be difficult to trade. Lack of diversification can also be problematic: Many of the green ETFs, such as Claymore S&P Water (CGW), focus on narrow niches. Others, such as Market Vectors Environmental Services (EVX), are highly concentrated in their top holdings. For these reasons we'd expect most green funds and ETFs to deliver a bumpy ride, and we'd recommend using them as specialty holdings.

Investors may have not yet seen these risks play out because many of the funds mentioned here have been on a strong multiyear run. And, valuations in a number of green sectors (especially solar and wind) are looking fairly rich. Therefore, investors buying in because of the recent hot returns will likely be disappointed if the general area cools off. Also, green funds are generally not cheap. Most of the green ETF expense ratios fall in the 0.50% to 0.75% range, which does not include the brokerage costs that come with buying and selling them. Similarly, the mutual fund options' levies range from 1.25% to a hefty 1.98%.

To Be Continued�
Although this article should give investors a good starting point, we'll dig deeper into green topics in future pieces. We're also considering adding a number of green funds to our regular coverage list. As a result, we'd welcome input from our readers on what kinds of coverage, tools, or products you'd like to see from Morningstar. Please let us know what you think by sending your comments to Michael_Herbst@morningstar.com.