Our Approach to Sustainability Investing

For the third straight year, Planet Earth set a record high average temperature in 2016. There is now a broad scientific consensus that our planet is warming due to increased emissions resulting in higher atmospheric concentrations of greenhouse gases (carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride). In response, many investors desire to align their investment decisions with their views on the importance of preserving the environment and mitigating adverse climate effects. There are several possible approaches to implementing a sustainability-oriented strategy, and all of them have benefits as well as pitfalls.

The first possibility for an environmentally-conscious investor is to sort through and pick out individual companies that he believes meet the criteria for inclusion in his portfolio. Of course, we are not only talking about the sustainability criteria but the risk/expected return requirements as well, not to mention the portfolio weighting decision. Unfortunately, most individual investors are ill-suited to these tasks. This is not a poor reflection on them, as many “professional” stock pickers are equally unqualified, based on the consistent underperformance of actively managed funds.

The second possibility is to outsource the security selection decision to a “green” mutual fund that invests exclusively in environmentally-related markets such as alternative energy, water treatment, pollution control, waste technology, and resource management. There are two distinct disadvantages to this approach: These funds tend to have higher expense ratios and they lack the diversification that a prudent investor should have. The lack of diversification means that returns can be very different from the overall market, which may be unacceptable from a planning perspective.

The third possibility (and Clarity’s approach) is to identify low-cost broad market funds that utilize sustainability as both an inclusion and a weighting criterion. Two of the funds that we use for sustainability-oriented investors are Dimensional’s U.S. Sustainability Core 1 Portfolio (DFSIX) and International Sustainability Core 1 Portfolio (DFSPX). As with DFA’s other core funds, they are tilted towards smaller, lower relative price, and higher profitability companies. Additionally, they are structured based on a sustainability scoring framework that considers industry groups as well as the broad universe of individual companies. That their approach is unique is evidenced by the three patents DFA owns related to sustainability investing. Consistent with current environmental concerns related to climate change, an overwhelming degree of emphasis (85% of the total sustainability score) is placed on greenhouse gas emissions for the purpose of ranking companies within an industry. The remaining 15% is derived from the following four factors:

• Land use and biodiversity
• Toxic spills and releases
• Operational waste
• Waste management

The top contributors to greenhouse gas emissions can be underweighted or excluded from the portfolio. Separate consideration is given to potential emissions from reserves, as certain energy companies are particularly vulnerable to future regulations limiting the amount of fossil fuels that can be consumed. Other environmental and social sustainability variables considered for the possibility of excluding certain companies are:

• Factory farming
• Cluster munitions manufacturing
• Tobacco
• Child labor

At Clarity, we are pleased to offer sustainability-oriented portfolios to our clients, and full disclosure, we have a significant portion of our own money invested in the two DFA sustainability funds discussed above. If you would like to learn more about our sustainability portfolios, please give us a call at 800-345-4635 or e-mail us at info@clarityca.com.

Source: "The Evolution of Sustainability Investing", Dimensional Fund Advisors, May 2016.