From directly investing in renewable-focused funds to avoiding fossil fuels, green-minded investors have many choices. (Getty Images)

The number of sustainable energy investments is increasing as more interest has been generated among investors seeking additional renewable options.

Investing in the alternative energy sector remains challenging, but a number of exchange-traded funds focus on specific sectors such as water or solar.

"The challenge of investing in renewable energy is that you are exposed to a good amount of policy risk," says Derek Horstmeyer, an assistant finance professor at George Mason University.

Here are four tips on how to invest in renewable energy:

Watch for greenwashing.

Returns can be impacted by government policies.

Increase diversification with ETFs and mutual funds.

Avoid fossil fuels.

Watch for Greenwashing

Investors are turning more to renewable energy options such as wind and solar energy in an effort to create a more sustainable footprint.

Not all sustainable investments are equal, and investors must scrutinize them closely beyond eliminating industries such as coal or oil and gas.

Investors also should look at more than just the name of a mutual fund or ETF because there is a lot of "greenwashing" out there, says Lisa Hodges, founder of Shift to Impact, a Washington, D.C.-based financial advisory firm.

"Just because a fund says it's green doesn't mean that's necessarily the case," she says.

A fossil fuel reserve-free fund might still invest in companies that distribute for and service the oil and gas industry, Hodges says.

The catch is that they just don't own the actual fossil fuel assets.

"Do your research on the fund's holdings and management to be sure they're truly committed to sustainability," she says. "Take advantage of As You Sow's excellent site. You can run any fund through their database and see how it stacks up."

Investors interested in reducing their carbon footprint turn to renewable energy investing to align their dollars with their values, says Mike Loewengart, chief investment officer at E-Trade Financial.

"While global consumption of clean and renewable energy continues to grow at a steady clip, investors looking to add exposure to their portfolio should understand the difference between traditional energy investments and renewable," he says.

Returns Can Be Impacted By Government Policies

Government policies and mandates regarding sustainable energy are newer compared with other industry regulations and increase the amount of risk in a portfolio.

"Since regulation, subsidies and things like international climate accords affect the returns of solar companies and other clean energy, this is a big risk an investor is taking on by investing in this space," Horstmeyer says.

Some of the key factors that drove the benefits to investing in renewable energy over the last decade are now creating some of the biggest challenges, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business.

The government subsidies that incentivized investors are now diminishing as the industry "matures with the growth of commercial financing, more private capital and demand," she says.

"This has put downward pressure on pricing and costs leading to possibly lower investment returns and higher volatility if portfolios are not properly diversified and managed," Gunzberg says. "While investors have long sought the ability to understand the environmental impact of their investments, the data and reporting is complex."

Renewable investments can be volatile and have the potential to face unexpected headwinds like government regulation and unpredictable weather, Loewengart says.

When the federal government dials down subsidies, solar stocks can take a hit.

"The easiest way to gain exposure is through ETFs and may help mitigate some of the risk associated with owning one stock," he says.

Increase Diversification With ETFs and Mutual Funds

While the number of challenges to investing in renewable energy has declined, some factors still exist. Renewable energy investing is becoming more prominent and accessible to the retail investor as the number of ETFs and mutual funds rises.

The challenge with renewable investing is that many of the opportunities to invest in renewable energy are untested through multiple market conditions, says Daren Blonski, managing principal of Sonoma Wealth Advisors in Sonoma, California.

"Investors who choose to invest in new approaches to generating energy are exposing their portfolio to higher-risk investments, and this can be problematic for long-term portfolio returns," he says.

Buying a renewable energy ETF or mutual fund can help investors maintain diversification with higher-risk investments.

There are many options for investing in renewable investments such as the Invesco Water Resource ETF (ticker: PHO), which invests assets in companies that seek to conserve and purify water, Blonski says.

The fund invests in 35 companies and a market cap of $1.2 billion with a relatively high daily volume.

"Although holding 35 companies wouldn't be considered vastly diversified, it's far more diversified than trying to buy individual positions," Blonski says.

Avoid Fossil Fuels

Before investing in a company or ETF, it's critical to conduct research since some funds are heavily concentrated in one area of the market or geographic region, Loewengart says.

"Some funds include nuclear investments that are considered renewable, but the socially responsible investor might want to steer clear from that segment," he says.

Green bonds are another option for investors seeking income from their portfolios as they get closer to retiring. These bonds are debt securities used to fund projects that will have a sustainable impact on the environment, Blonski says.

"Green bonds are a way for an investor to participate in investments that have a positive impact on the environment but also offer the commitment of being paid back by the borrower," he says. "This can be less risky than buying renewable energy stocks that do not have a commitment to be profitable."

The credit ratings for green bonds are generally the same as bonds from the same issuers, Gunzberg says.

"They mostly trade like other unsecured debt with only some slight differences from the supply and demand that can lead to tighter trading," she says.

One downfall of green bonds is that they remain a comparatively new market, "making them relatively niche and harder to analyze from a lack of robust historical data," Gunzberg says.

"Green bonds generally have long maturities, making them susceptible to interest rate risk," she says. "Corporate green bonds tend to be concentrated in energy, utilities and real estate. Given the sector concentrations and long maturities, green bonds don't neatly replace traditional bond portfolios."

Investors can add sustainable investments by including assets that focus on climate change, water scarcity, waste management, food availability, health and wellness and the improvement of lives and demographics, Gunzberg says.

Green bonds are relatively new and getting lots of attention, partially due to their scarcity, Hodges says.

"Apple is famous for using them," she says. "I think they're overshadowing their more mundane but possibly more useful cousins such as green municipal bonds and Community Development Financial Institution notes."

One factor investors should consider is that the impact of climate change will be felt locally and under-resourced communities will be hit hardest, Hodges says.