Understanding the pros and cons of sustainable investing

April is Earth Month, and this year’s was extra special as it included the 50th anniversary of Earth Day.  The annual event was launched in 1970 by U.S. Senator Gaylord Nelson as a nationwide teach-in. Back then, an estimated 20 million Americans took to the streets to draw attention to environmental disasters and to demand action to protect the Earth. This year’s efforts were understandably more muted, and yet the environmental crisis is more urgent than ever.

Fortunately, there are plenty of ways that you, as an individual, can have an impact through responsible investment decisions. One of those ways that you might not have considered is socially and environmentally responsible investing—essentially, using your dollars to support sustainably-minded businesses, while withdrawing investment funds from those who are damaging the planet.

Of course, if sustainable investing were as simple as that sounds, everybody would be doing it. But investing—already a complicated thing—in a way that’s socially responsible takes time and effort. You’re in the right place to start, though, with this guide to what environmentally responsible investing is, and what the pros and cons are.

What is environmentally responsible investing?

If you search for “environmentally responsible investing,” the results likely will show a whole slew of other terms ranging from green investing to socially responsible investing to sustainable investing. The latter – sustainable investing – is the most commonly used term, but it doesn’t have a widely accepted definition, says Henry Shilling, director of research at Sustainable Research and Analysis.

“Practitioners in this space agree there are several different approaches to achieving sustainable investing,” Shilling says. Those can be boiled down to four main approaches.

Values-based investing

This strategy involves choosing investments for your money that align with particular religious, ethical or social beliefs. Typically, values-based, socially responsible investing entails screening out companies or sectors – such as companies that produce alcohol, tobacco or firearms.

Impact investing

This approach involves achieving a measurable social or environmental impact with your investing. For example, it could include investing in companies that promote gender equality in the workplace or seek to reduce greenhouse gas emissions.

Thematic investing

This strategy is similar to impact investing. It targets specific areas such as, say, investing in alternative energy sources, but it doesn’t necessarily involve achieving measurable outcomes.

ESG investing

Shilling says that ESG is the fastest-growing approach to sustainable investing. It takes into account companies’ environmental, social and governance practices. As an investor, it’s important to be aware of these distinctions. These ESG factors will come into play as you weigh your sustainable investment options.

Ways to invest: stocks vs. funds

One way to ensure that your money is being invested in a way that supports environmental causes is to buy shares of companies that align with those causes. For example, if you support clean energy, you might want to purchase shares of a solar panel manufacturer.

However, picking stocks on your own might not be the best option if you’re new to investing. “For investors who are starting out, they may be better off relying on professional fund managers to build a core portfolio then work their way out from there,” Shilling says. That means buying mutual funds rather than individual stocks.

Mutual funds invest in a variety of stocks, bonds or other assets. The assets are chosen by professional fund managers based on the goal of the fund. As an investor, you can buy shares in a mutual fund and get instant exposure to several companies. That can help lower your risk because all of your money won’t be tied up in the fate of just one company.

In addition to actively managed funds, there are exchange-traded funds and index funds — both of which track the performance of a market index such as the S&P 500. However, ETFs typically have no or low minimum investment requirements, so they can be a more affordable way to start investing. They also trade on the stock market, so the price can go up or down during the day. Index funds only trade once a day.

There are almost 1,000 mutual funds and ETFs that pursue a sustainable investing strategy, Shilling says.  Many of the large investment firms – including Fidelity Investments, Morgan Stanley and Vanguard —– offer sustainable funds. “This is probably a time when investors have more options in the sustainable investing space than they’ve ever had before,” he says. “On the one hand, it’s a good time for investors because they have more options. At the same time, they have greater challenges sorting through the options.”

How to choose investments that align with your values

Before sorting through all of the socially and environmentally responsible investing options, Shilling says you need to get clear on what your values and investing goals are, especially because there aren’t standardized definitions and classifications for sustainable funds.

For example, one fund might be labeled as “clean energy” because it focuses exclusively on alternative energy companies. And then a second fund might also be labeled “clean energy” because it, too, focuses on alternative energy companies—and yet it might also work with companies that are then involved in the distribution of fossil fuels. “Even when you think a term like environmental will isolate funds that will focus on that attribute, the funds themselves might approach environmental considerations in different ways,” Shilling says.

In short, you can’t rely on the fund name alone. So what’s an environmentally responsible investor to do?

Review the fund’s objective for sustainable investment practices

Mutual funds are required to issue a prospectus with detailed information about the fund. Often, you can download a copy of the prospectus by visiting a fund’s website, or you can find current holdings in the fund’s most recent annual or semi-annual report. The prospectus will include an investment objective and the types of securities it invests in, which you should review to see if the objective and holdings align with your values. You should also consider the fund’s risk profile to ensure it’s consistent with your risk tolerance.

Review the fund’s performance

Check the average return of the fund over varying periods of time to see how it performed, and compare that performance to an appropriate benchmark — such as the S&P 500 or Dow Jones Industrial Average. You can find performance information in a fund prospectus, or you can use the Financial Industry Regulatory Authority’s Fund Analyzer. You don’t want to choose a poorly performing fund just because it aligns with your values.

Review fund fees

Mutual funds have a variety of fees, including fees to cover the costs of operating the funds. The higher the fees, the more they will eat into the fund’s returns. You can compare the fees for sustainable funds by using FINRA’s Fund Analyzer. Search by fund name or symbol, and the Fund Analyzer will show how its fees compare with fees of similar funds.

The tradeoffs of environmentally responsible investing

There can be some drawbacks to aligning your investments with your values. For one, the fees for sustainable funds tend to be slightly higher on average than for conventional funds, Shilling says. “But within that group, it is possible to identify funds that are attractively priced,” he adds.

It also can be difficult to gauge the performance of these investment funds because many have only been around for a couple of years. For example, “Some reports would lead you to believe that these funds have been performing better in this market downturn,” Shilling says. One reason some of these funds have performed well lately is because they don’t invest in traditional energy companies, which have seen their shares fall significantly lately. (Negative oil prices, anyone?) Sustainable funds’ recent performance might not be an indication of how they’ll perform over the long-term.

Plus, if you’re only investing through a 401(k) or workplace retirement fund, you might not have access to environmentally responsible funds. That’s because 401(k) plans have been slow to offer these types of funds as investment options, Shilling says.

If your workplace retirement plan doesn’t include any sustainable fund options, let your employer or human resources department know that you’d like to see these sorts of funds added to your investment options. “As more employees express an interest in something like this and as more options become available, you’re going to see an increasing adoption rate with 401(k) plans,” Shilling says.

Is environmentally responsible investing worth it?

You might be wondering whether this type of investing is worth the potential trade-offs. After all, it might not seem that you’re making much of a difference as an individual investor by opting for shares of environmentally responsible companies or sustainable funds.

However, your investment choices do have an impact, Shilling says. “You’re making a statement that you care,” he says. “By expressing that care and concern in the way you allocate your money, you’re sending a signal to the investment community.”

Over the long term, increased demand for sustainable investments can lead to the creation of more funds that focus on companies that are making a positive environmental impact. That, in turn, could drive more companies to take on the mandate of improving the environment through sustainable efforts.