It seems that everyone is turning green—whether that means buying energy-efficient light bulbs, opting to cook their free-range beef and organic vegetables on a solar grill, campaigning to save the Alaskan wilderness from oil exploration or rocking to downloads from July's Live Earth concert.

For financial advisors still struggling to address the challenges of building socially responsible investment (SRI) portfolios, demands by a growing number of clients to narrow their investment horizons still further to "green" businesses are creating a host of new complications. "This isn't like long-term-care insurance, which all our clients want to know about at every meeting; but it's coming up with more frequency, and we have had to find ways to address it," says Mark Brown, a fee-based planner and managing partner of Denver-based Brown & Tedstrom. "The problem is that building a green portfolio is not an easy job."

That may be the understatement of the decade. Even as assets continue to flow into the growing number of green investment products, the debate over what companies and investment products should carry the green label continues. (Morningstar calculated that assets in the 20 green mutual funds and ETFs it tracks had hit $9.5 billion by June 2007.)

Then there's the even bigger question of whether it's possible to build an entirely green portfolio. Even the word green sparks heated debate: What may be bright green to one client or advisor may be murkier to another.

Out of the Shadows

As environmental issues take center stage in the political and business worlds, the time is coming for financial advisors to take a hard look at some of these controversies and begin to address them. "Increasingly, baby boomers are seeing these issues as important enough to want to express them in how they manage their money," says Brown, whose firm manages some $300 million in assets. "[Green investing] is coming out from underneath the shadow of socially responsible investing."

Indeed, many planners say their green clients may once have been content to invest in one of myriad socially responsible funds, many of which select holdings based on environmental criteria—in addition to considerations such as workplace policies, human rights and good governance.

Today, however, these clients are demanding a more targeted approach, and Wall Street is delivering. Once, the universe of purely green investment vehicles was limited to the Sierra Club Fund and Portfolio 21; today, investors can access some half-dozen mutual funds and at least as many ETFs (see "Green Portfolio Resources," below), some of which focus on specific subsectors such as alternative energy and clean water.

And separate account managers tout their skill at winnowing through the universe of large, mid- and small-cap stocks in search of those with the best environmental report cards. Even Wall Street's research analysts are getting into the act, picking companies that may prosper as the investment and policy climate take on a green tint.

What Green Clients Want

Patricia Edwards, managing director and portfolio manager for Wentworth, Hauser and Violich in Seattle, a fee-based wealth management firm, recently overhauled the SRI portfolio of one of her clients. The client, a woman in her thirties, wanted to narrow her portfolio to address her primary concerns: climate change, hazardous waste, ozone-depleting chemicals, nuclear energy and the ecological impact of agricultural chemicals. "We culled the stocks that might have made the grade under the previous socially responsible criteria, but didn't reflect this narrower approach," Edwards says.

Out went 3M, for instance. Though it meets the test of many socially responsible funds on a broad array of issues, the environment isn't one: The company has tangled with environmental regulators and, in the client's eyes, its carbon emissions are contributing to global warming.

For Edwards, as for other advisors who have navigated this tricky path, the key factor is what a client sees as harmful to the environment. "I can't make that determination for anyone," she says. "Yes, it means more work for me with each client, but figuring that out is part of my job." To start the process, Edwards asks clients who request a green portfolio to fill out a detailed questionnaire, designed to determine exactly what each client means by green, sustainable or environmentally sensitive investing. "These can be catchphrases that have different meanings for different individuals," Edwards explains. The process can be as easy as pinning Jell-O to a wall.

Some of the biggest, yet simplest, flashpoints are around the energy industry. For a large majority of environmentally concerned investors, owning shares in oil and gas production, exploration or service companies is an absolute no-no.

But what about nuclear energy? To nearly as many, it's anathema because of the radioactive waste produced as a byproduct of generating electricity at nuclear power plants. But to a handful, it may be acceptable as a viable, cleaner-burning alternative to fossil fuels, especially in the absence of a large-scale, environmentally benign power source.

More Choices

Still, investors concerned about global warming have a far greater array of investment opportunities available to them than they did in the recent past. Even two years ago, the majority of the most compelling investment opportunities were often open to only the wealthiest and best-connected investors—those with a net worth well into the millions and the clout needed to get into the typically tiny venture and private equity funds concentrating on alternative energy.

Today, advisors don't have to beat their heads against a wall trying to get their clients access to those vehicles; instead they must winnow through the growing array of public market vehicles that bill themselves as green. "The question isn't what is there to buy, it's what is best to buy for our clients—there's now a whole range of approaches we could take," says Bob Dreizler, a Sacramento, Calif.-based advisor with First Affirmative Financial Network.

Over the past year, several mutual fund firms, such as Calvert and Guinness Atkinson, have launched funds dedicated to alternative energy, and others have created ETFs. "It's very difficult for advisors and investors to pick stocks themselves within this space," argues Adam Phillips, director of ETF sales for Van Eck Global, a New York investment firm that launched an alternative energy ETF in May.

"There are so many new and unique technologies around the world, and if you're going to just pick a few, you need a lot of expertise in that sector."

Even experienced managers can find building these portfolios troublesome, admits Paul Hilton, director of social investment strategy for Bethesda, Md.-based Calvert.

The number of publicly traded securities in which Calvert's new alternative energy fund can invest is constantly growing, but often, the companies with the most promising technologies are acquired by larger rivals. "You also have to diversify—buying companies making solar panels of different kinds, and buying biofuel producers which aren't just doing ethanol." Calvert's solution to the latter? D1 Fuels, a company making a biofuel from jatropha, a family of shrubs and trees indigenous to India (where jatropha is currently being used to make fuel) as well Africa, North America and the Caribbean.

Customization is Key

If oil and gas producers are considered "bad" investments in the eyes of green-oriented clients, alternative energy companies are likely to be at the opposite end of the spectrum most of the time. But even here, advisors need to be prepared for the diverse ways in which their clients may perceive the world. For instance, while investing in an ethanol company may seem like an easy call, some clients may feel that the emissions advantages don't outweigh the environmental costs of producing corn, ranging from the chemicals and fossil fuels required for fertilizers to the impact of high-intensity corn farming on the soil. Wind farms don�t pollute, but they can be noisy eyesores that have a less-than-benign impact on local birdlife.

"That's why I use questionnaires to try to get at what kind of tradeoffs clients will accept, because there is almost always going to be one," says Patricia Edwards. Some clients will like the idea of investing in General Electric, because the firm is making such large-scale investments in pioneering renewable energy development projects. Others will balk at the idea of owning shares in a company that polluted New York's Hudson River and is still involved in the nuclear energy business. Edwards notes that her questionnaire is just a starting point. "Then we'll talk about what is acceptable and what isn't," she says.

Edwards, whose firm requires clients to have a minimum of $1 million in assets, then turns to IW Financial, a research and consulting firm with headquarters in Portland, Maine, for help in structuring a highly customized portfolio. Say a client places a higher value on investing in companies that don't create waste than on those that are developing technologies to reduce carbon emissions. IW Financial can come up with a list of stocks that reflect even such fine-tuned preferences. IW's clients, who tend to be advisors working with high-net-worth investors, family offices or institutional investors, can ask the firm to do everything from identifying a money manager who adheres to a specific set of green criteria to creating a green index against which investment results can be measured.

Understanding Tradeoffs

One of the biggest tradeoffs is also the most difficult for advisors to discuss: the problems of building a portfolio that will simultaneously meet the client�s financial objectives and mesh with his or her environmental convictions. "No one goes into this wanting to be partly green with their portfolio," says Mary Rinehart, chief investment officer of Rinehart & Associates, a Charlotte, N.C.-based fee-only planning firm. "They may have different definitions of what green is—but they don't want to compromise anywhere in their portfolio." Advisors remain divided on whether it's possible to build a "pure green" portfolio that still meets an individual's financial goals. Most funds, from the nearly decade-old Sierra Club Fund to newer offerings like the Winslow Green Growth Fund, end up investing in very similar industries and companies—and excluding large chunks of the market.

"Even outside the natural resources industry, there are sectors where it's tough to identify a stock that has good fundamentals and also passes muster on environmental criteria," says Andrea Kotch Duda, vice president of investments at Raymond James in Ann Arbor, Mich. "Some older, well-established companies aren't prepared to make changes in the way they do business." The more purist the investor, the less likely it is an advisor will be able to craft a diversified portfolio that meets a client's financial and social objectives. "Then the issue becomes being very clear about what the tradeoffs are, so that volatility and periods where the portfolio really lags don't come as a nasty shock," Kotch Duda adds.

In the Black 

To be sure, many green mutual funds are posting solid returns these days, especially those that have built up overweight positions in alternative energy stocks. Valuations in that area of the green investment universe have soared as more and more assets from both public and private investors have flowed into the coffers of even the newest and tiniest players. In 2006, the latest period for which full data is available, the National Venture Capital Association reported that $1.53 billion was funneled into 235 investments in alternative energy startup companies. That's up from about 100 such transactions valued at a total of $576.6 million in 2000, and brings the total invested in such businesses to $4.2 billion over the past seven years.

Those new companies that have gone public have often fared very well, posting market gains that remind some market analysts of the heady days of the dot-com era a decade ago. Shares of Suntech Power Holdings, for example, roared 35% higher in its first day of trading, and now trades at roughly $33 per share, or 43 times estimated earnings, more than double the average price/earnings multiple. But along with stellar returns comes outsize volatility: VeraSun Energy, another solar energy company, has seen its stock price halved in the past year.

Most planners are likely to find that their clients focus more on their philosophical convictions and recent returns than they do on the risks of building a strictly green portfolio. And that's where an advisor needs to be prepared to spell out, in detail, the likelihood of higher volatility.

At the very least, says Edwards, they should caution clients against comparing their portfolio's return with that of the Standard & Poor's 500, which has a 10% weighting in the energy sector, another 4% in utilities and still more in materials and industrial companies. "Those are the sectors that will typically be completely missing or drastically underweight in a green portfolio, so your chances of having a green portfolio track the S&P are pretty minimal." The challenge is that there isn't a current widely accepted benchmark for green portfolios, so clients won't be able to follow their performance in a way they might be accustomed to.

Shades of Green

Still, as green investing reaches toward the mainstream, new product offerings are taking a less purist approach. A case in point comes courtesy of Fred Alger Management, which decided late last year to transform its SRI fund into a green fund. Rolled out in January, the Spectra Green Fund—part of Alger's family of no-loads—is an attempt to build an environmentally benign investment vehicle that could be used as a core holding by many clients. Rather than screening out bad stocks, says Zachary Karabell, chief economist at Alger Management, the fund's managers seek out companies that follow environmentally sound policies, regardless of the industry they're in.

The result, he posits, is a growth fund based on environmental principles. "One of the biggest ways in which companies can boost their bottom line and have a positive impact on the broader world in which they do business is to address environmental sustainability, whether it's by looking at energy-use policies or their supply chain," he says. Karabell doesn't want the Spectra Green Fund to be viewed as a niche offering, suitable only for diehard super greens; indeed, he admits the fund is likely to own many stocks that this group would be horrified to find in their portfolios, such as energy producer BP (included because of its efforts to invest in renewable energy businesses).

Die-hard environmentalists and managers of veteran green funds like the Sierra Club Fund may view this kind of offering as a cop-out. But to Karabell, his fund's philosophy is simply the next logical step as more diverse investors flock to green investments. "We all make compromises—unless you go live in Alaska with a biofuel generator, use a computer made of recycled materials and don't have anything in your home with chemicals or artificial fibers," he says. "We live in the real world, and if we want environmental policies and practices to change, the major players will have to act—and be rewarded for being proactive."

Suzanne McGee is a New York–based freelance writer who covers business, investing and philanthropy. She frequently contributes to Financial Planning.