Judging from the prolifera­tion of new indexes over the last decade, it seems almost certain that wherever there is a hot investment trend, an index is sure to follow. So it goes with sustainable investing, a relatively new concept that seeks to connect the dots between good corporate behavior and superior stock performance.

Corporate sustainability analysts believe the environmental, social and governance (ESG) behavior of a company can determine whether it is likely to survive and thrive over the long term. Proponents of this approach say they can uncover better-managed companies by focusing on features such as good environmental track records, diverse managements or boards, transparent financial reporting and prudent lending practices, as well as by filtering out companies who are weak in these areas in ways that could come back to bite investors.

Sustainable investing differs from its better-known cousin, socially responsible investing, in a number of ways. It does not involve screening out so-called "sin stocks," such as those companies manufacturing tobacco, alcohol or weaponry. It takes no position on religion, abortion or vice. Instead, it shifts the focus from values to more hard-nosed financial considerations such as corporate financial reporting, risk management techniques and environmental responsibility.

Proponents see sustainable investing as more encompassing than SRI, with a greater potential to grow into a mainstream investment philosophy. "Over the next 15 years, I think there will be a transition from the old world of socially responsible investing to the new world of sustainable investing," says Joseph Keefe, president and CEO of Pax World Management, which has a family of SRI mutual funds. Keefe says the discipline points investors in the direction of better-managed companies and that there is overwhelming evidence that environmental, social and governance factors make for better investing.

A Growing Product Roster
A number of sustainability indexes, and products based on them, promise to bring sustainable investing to the masses. Dow Jones' series of sustainability indexes (DJSI) have been around since 1999 covering both U.S. and foreign markets. In the U.S., the Dreyfus Corporation licenses one of these indexes for its Dreyfus Global Sustainability Fund, and State Street Global Advisors uses another for separate accounts. In late April, TD Asset Management launched the TDAM Global Sustainability Fund, which draws its investments from the Dow Jones Sustainability World Index.

A Dow Jones spokesperson says several other U.S. funds have registered with the SEC as well for new portfolios based on these indexes.

Other funds are tapping sustainability indexes forged by KLD Research & Analytics in partnership with U.K.-based FTSE International in a co-branding deal begun in May 2009. KLD's three sustainability indexes include the FTSE KLD Global Sustainability Index, the FTSE KLD North America Sustainability Index and the FTSE KLD Europe Asia Pacific Sustainability Index.

KLD's global index forms the basis for a fund launched by Northern Trust and variable annuities from TIAA-CREF. Pax World also plans to introduce a suite of investment products based on the FTSE KLD indexes, including ETFs, mutual funds and separately managed accounts, though no launch date has been set.

In addition to its co-branded KLD products, FTSE also has the FTSE Environmental Markets index series and the FTSE4Good. The latter is used by Vanguard's FTSE Social Index Fund.

Meanwhile, Dimensional Fund Advisors, a major provider of enhanced index funds, draws from an eligible investment universe provided mainly by a company called Sustainable Holdings for its U.S. Sustainability Core 1 Portfolio and the International Sustainability Core 1 Portfolio.

Companies that license such indexes use them in different ways. Northern Trust simply replicates the FTSE KLD index in its mutual fund. TIAA-CREF customizes the portfolio by adding a layer of financial screens. The Dreyfus Global Sustainability Fund also uses financial screens and may include companies not in the Dow Jones index according to its own sustainability criteria.

Finding an Audience
Whether these funds become popular will depend largely on how well they perform. Most of them have short track records, even if studies suggest that the companies in their universe are superior in many ways. Management consulting firm A.T. Kearney conducted the most recent study, examining 99 of the largest companies from two sustainable investment indexes, and found that companies in 16 out of 18 industries outperformed the market averages by 15% over the grueling six months from May through November of 2008.
The report concludes, "Most sustainability-focused companies may well emerge from the current crisis stronger than ever."

But the evidence from this and other studies is by no means conclusive, and sustainable investing has been the subject of some controversy and confusion. In their book Business Ethics, published by Oxford University Press, professors Andrew Crane and Dirk Matten note that the data used to determine whether a company is accepted into the Dow Jones series of sustainable indexes is based largely on questionnaires, submitted documentation, public reports and other information provided by the company itself. Although the data is analyzed by an outside consulting firm and verified by an independent auditor, "the assessment is basically an inside-out provision of data," they conclude. Keefe argues that sustainability analysts have access to the same information as other kinds of analysts, and have no particular advantage or disadvantage when it comes to obtaining information from companies, either from public sources or firsthand research.

Still, the occasional appearance of notable corporate transgressors in sustainability indexes shows that no research methodology is foolproof. In September 2007, less than two years before its colossal implosion, American International Group appeared in the Dow Jones North American sustainability index (it has since been removed), and even in late January 2008, a leading global research firm was naming AIG as one of the 100 most sustainable companies in the world. Troubled mortgage giant Freddie Mac, meanwhile, boasted a listing in KLD's Global Sustainability Index and was removed only in September 2008 after the U.S government was forced to rescue it. Bailout recipient Washington Mutual got booted from the index the same month.

There is also some confusion about exactly what "sustainable" means, and no standard industry definition. DFA's sustainability portfolios focus on environmental impact considerations, yet the firm's fact sheets make no mention of governance practices or social criteria. By contrast, the FTSE KLD, Dow Jones and FTSE4Good indexes have much broader mandates. Some of the indexes apply financial screens, while others only look at sustainability characteristics and leave it to the product sponsors to apply financial and valuation criteria.

Others point out that traditional "sin" companies like tobacco companies and defense contractors are fair game for these indexes, too. The DJSI World Index, for example, includes tobacco maker British American Tobacco and spirits maker Heineken. (Dow Jones has separate sustainability indexes screening just for social concerns, though these aren't yet used in any U.S. products.) Still, DFA's sustainability portfolios list Wal-Mart among its top-ten holdings, a company long criticized for spurning unions and selling goods produced by cheap overseas labor.

Sustainable investing also often includes "clean and green" index portfolios such as the popular PowerShares WilderHill Clean Energy Portfolio (PBW), the PowerShares Cleantech ETF (PZD) and the First Trust NASDAQ Clean Edge Green (QCLN). With the increasing focus on alternative energy and global warming, the number of environmental indexes and products based on them has grown in the last couple of years. But because they often focus on smaller companies and are in a single sector, these funds and ETFs are typically more volatile than a broader sustainable investment portfolio.

Just as the definition of sustainability investing seems to be a moving target, the line between this discipline and what might otherwise be considered simple, old-fashioned investigative fundamental analysis can become blurred as well. Investment managers of all stripes would likely avoid companies with bad environmental track records just because of the litigation concerns. Or they might otherwise likely analyze the sustainability of earnings and look for financial smoke screens, scrutinizing executive compensation or board voting records. What some might call sustainability analysis others might just label a comprehensive financial checkup.

Thomas Kuh, managing director at KLD Analytics, acknowledges that sometimes people in his field cross over with traditionalists, but says "our analysts have greater sensitivity to sustainability criteria and a more systematic and comprehensive approach to finding companies with sustainable characteristics." He adds that while a company-by-company evaluation of components in his firm's indexes might reveal a few bad apples, "the companies in our indexes, as a whole, have a higher level of sustainable qualities than those in the broader indexes."

Keefe also acknowledges the crossover, but says mainstream analysts typically do not apply the same rigorous and systematic ESG criteria that specialists do. "Over time, a portfolio of sustainable companies has distinct advantages over a portfolio of companies without those characteristics. Positive ESG practices show that a company is forward-thinking and preparing well for the future."