Environmentally Responsible Investing

Green investing has traditionally meant the following:

– Exclude sectors of the economy or individual firms that are the most polluting.

– Hire a money manager to do the best he can in the rest of the stock market.

So typically, Chemicals, Oil, Paper Manufacture, etc. would be excluded. The money manager finds himself in a universe providing him with less economic sectors, less ability to diversify. He is optimizing his portfolio under a constraint, he is operating with a statistical handicap.

I have never liked this approach. For one thing the performance of such green funds tends to be underwhelming. So the investor ends up worse off for being green. But also, that all or nothing constraint is really unfair. What about the CEO of a chemicals company who really tries hard to develop environmentally friendly products? Why should he be starved of capital? And inversely, why should the CEO of a software company be automatically considered for investment? Shouldn’t you also push him to make environmental sustainability efforts? Wouldn’t it be better if the environmental efforts of any CEO were taken in the context of their industry? Finally, I find it not very responsible to penalize entire sectors of the economy, simply because they are polluting. We live in a world where all sectors are interdependent, without dirty Chemicals, there would not be clean Software, without dirty Oil there wouldn’t be much of anything. There must be a better way.

Here is the method that Dimensional Funds has developed:

1. Measure the environmental sustainability of all publicly traded company in the U.S and international markets.

Sustainable Holdings developed for Dimensional Funds, a method that:

– is rigorous, objective, data based

– is carried out by a strong team of experts from the Yale Center for Environmental Law and Policy.

Measures from 0 to 3 in 13 factors are assigned and then summed up in the proportion indicated in the table below.

For example, Home Depot ends up with 1.700 (out of 3) and Lowe’s with 1.373

2. Divide this measure by the average for that economic sector.

For example, if the average for all companies in the retail sector is 1.5, the normalized measure for Home Depot will be 1.700/1.5 = 1.133 and for Lowe’s 1.373/1.5=0.919

This ratio is measuring how well companies are doing toward environmental sustainability, compared to their peers in the same sector.

3. Penalizing the worst offenders of each sector of the economy.

For each sector of the economy, Dimensional assigns a weight of 0 to the companies that have normalized measures in the lowest 10% , for others the weight is the normalized measure. This way all companies quoted on U.S or international markets now have a weight reflecting their sustainable behavior.

4. Creating clones of existing Dimensional funds.

DFVQX is an existing Dimensional fund covering international markets and emphasizing small and value stocks. The composition of each of the stocks composing this fund can be multiplied by its sustainable weight. This is how Dimensional created a new fund called DFSPX. I call DFSPX a sustainable clone fund of DFVQX. Indeed, they have just about the same sectorial diversification and performance. They contain just about the same stocks, except that DFSPX excludes the 10% worse offenders of each sector and give more emphasis to the better behaved companies.

I find this approach to be a nice breakthrough. It does send a message to all CEO’s of all industries to improve their environmental sustainability. The green investor is not penalized anymore. Furthermore, the use of the rather recent “sustainable clone” funds takes advantage of the longer history available for the “classic”Dimensional funds that they closely track. If you are a client of Anselme Capital you should know that I use “classic” Dimensional funds to construct the A family of portfolios. The sustainable clones of these funds are used in the S family of portfolios.

The following table shows the factors considered in sustainability measure:

Belledonne Chain emerging from the clouds in the distance. Why wouldn’t you want to send a sustainability message?

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Originally published at anselmecapitalblog.com on February 20, 2013.