It's easy to roll your eyes at socially responsible investing. Maybe it's because the term suggests that other types of investing are, well, socially irresponsible. Look past its practitioners' sense of moral superiority, however, and you'll discover that some funds have more to offer than good intentions.
Traditionally, socially screened funds (our preferred, nonjudgmental term for the group) shunned stocks of companies involved in alcohol, tobacco, gaming and weapons. But as other funds that adhere to green and religious tenets have come into being over the past decade, screens have expanded to include such matters as corporate governance, environmental records and workplace standards. Some funds with a socially conservative bent will not invest in companies that make products that facilitate abortions.
In 2000, fewer than 75 socially screened funds existed. Today, more than 150 traditional, open-end funds and 17 exchange-traded funds employ various social screens. But socially screened funds are still a speck in the fund universe. As of April 30, investors had only about $55 billion in them, according to Morningstar. That figure represents roughly 0.5% of the fund industry. For perspective, Growth Fund of America -- the largest U.S. stock fund -- has $163 billion in assets. However, the Social Investment Forum says that in the U.S., socially screened portfolios -- which include pension funds, endowments and foundations, as well as mutual funds -- held $2.7 trillion at the end of 2007, the trade group's most recent figure.
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The costs of screening
To be sure, socially screened funds have high hurdles to clear. Small asset bases and the additional costs to screen companies on the basis of ethical, religious and political standards mean the funds tend to charge slightly higher operating expenses than conventional funds.
What a socially screened fund accepts and rejects can play a big role in shaping its portfolio. The funds tend to skimp on industrial and energy stocks, which often fail environmental tests. But health-care and technology stocks are common holdings because screening criteria often favor those sectors. This can lead to portfolios that differ substantially from their conventional peers. Some funds rely on "best in class" rankings to pick the most socially outstanding performer in each sector. That approach may increase diversification, but it will likely result in the inclusion of stocks that offend some investors. For example, TIAA-CREF Social Choice Equity holds McDonald's (a target of the healthy-eating crowd) as well as several oil companies, which may offend environmentalists.
The inability to invest in the panoply of investment choices may explain why most socially screened funds have lagged in recent years. Over the past five and ten years through May 7, about 65% of these funds trailed the average return of their peers. Over the past three, a period that includes the performance of the rash of newer funds, 60% lagged their peers.
But investors don't buy averages, they buy specific funds. Just like anything else in the fund business, choices matter. That's why we selected seven outstanding socially screened funds that are worth considering. The list includes six no-load funds with solid records and strong management teams, and one ETF.
Following Islamic tenets
Amana Income (symbol AMANX) and Amana Growth (AMAGX) are not just top performers among religious funds; they also stack up with the best in their categories, socially oriented or not. Following Islamic principles, the funds spurn financial companies, pork producers and firms involved in pornography. They also adhere to the standard social screens that eliminate alcohol, gaming and tobacco firms.
The picky filters shielded the Amana funds from the brunt of the financial crisis but have been a drag on returns during the subsequent bull market. Over the past five years through May 7, Amana Income ranks in the top 1% among funds that invest in large, undervalued companies. But mainly because financial stocks have rallied so sharply, Amana Income lands in the bottom 7% of its category over the past year. It's a similar situation with Amana Growth, which invests in large, growing companies.
Longtime manager Nicholas Kaiser, who runs both funds, likes companies that pay increasing dividends. Amana Income has long favored big drug companies, such as Johnson & Johnson, Pfizer and Abbott Laboratories. And technology giants, such as Apple, Cisco Systems and Oracle, play a major role in Amana Growth.
Big on alternative energy
Leslie Christian, lead manager of Portfolio 21 (PORTX), says she is serious about sustainability. By that, she means she wants companies that develop ecologically safe products using renewable energy and efficient manufacturing processes. "It's something we must do as a society or we will die," she says.
Portfolio 21 has a long list of no-nos. The fund does not invest in the types of stocks traditionally excluded from screened funds. It also shuns companies involved in nuclear power, a stance that even some environmentalists have begun to question, given clean-burning nuclear's potential as a solution to the problem of global warming. Plus, Portfolio 21 vets com-panies on workplace issues, human rights, community involvement and product safety. Thankfully, the fund's Web site (www.portfolio21.com) details the reasons stocks are rejected on social grounds. For instance, the fund's managers last year rejected MasterCard because the company wouldn't disclose how much energy its service centers use.
Christian scours the globe for stocks of large, growing companies that she thinks are reasonably priced. Google is a top holding, along with Nokia, the Finnish mobile-phone producer, and Vestas Wind Systems, a Danish supplier of wind turbines. Christian currently favors health-care stocks for their defensive qualities.
Christian's tough rules mean the fund is typically light on energy and financial stocks. But the restrictive approach appears to have paid off. Over the past five years, Portfolio 21 returned an annualized 3.9%, an average of one percentage point per year more than the return for funds that invest in stocks globally.
Seeking cheap stocks
Bargain hunters are unusual among socially screened portfolios. Only 13% of such funds focus on stocks their managers think are undervalued. In this small club, Appleseed Fund (APPLX) is a standout.
Appleseed won't invest in companies that generate revenue from alcohol, gambling, pornography, tobacco or weapons. The fund's five co-managers want good companies that have been beaten down by a temporary problem and are poised for a rebound. "We like to buy straw hats in February and sell them in June," says Josh Strauss, a co-manager. Above all, they are looking for a low share price relative to earnings, sales and other fundamental measures. And they invest in just about anything that they think is cheap. So they own giants, such as Coca-Cola, as well as K-Sea Transportation, a tugboat operator with a $160-million market capitalization. At last report, Appleseed also had 8% of its assets in an ETF that tracks the price of gold. Strauss sees gold as a hedge against the rampant inflation he expects in the coming years.
Appleseed, which started up in December 2006, has posted an impressive record in a short time. The fund gained an annualized 4.6% over the past three years, beating Standard & Poor's 500-stock index by an average of 12 percentage points per year.
Examining the goods
Todd Ahlsten, manager of Parnassus Equity Income (PRBLX), dives deep into a company's operations before and after he buys. He recently toured a coal-fired power plant to see how its owner -- MDU Resources, a longtime holding -- disposed of ash. He prefers to meet company executives and their suppliers, if he can. He views Parnassus's rigorous screening process as an important step in dodging bad investments. "I spend most of my time working on how we can avoid losing money," says Ahlsten.
Parnassus has delivered steady results with a relatively concentrated portfolio of about 40 stocks. Over the past five years, the fund returned an annualized 6.0%, which puts it in the top 1% of funds that invest in large companies with a blend of growth and value attributes.
Quality shines through in Parnassus's portfolio. About 75% of its holdings pay dividends, and stocks of global powerhouses, such as Microsoft, Procter & Gamble and Johnson & Johnson, are among the fund's top holdings. Parnassus rejects stocks of heavy polluters, as well as companies involved in alcohol, gaming, tobacco and weapons. The fund has significantly less exposure to energy stocks than the S&P 500, but it does hold Energen, which explores for energy and distributes natural gas.
Tracking an index
TIAA-CREF Social Choice Equity (TICRX) has been adept at following the broader market without sacrificing returns. The fund chooses about 1,000 stocks from the Russell 3000 index that score well based on five standards, including use of natural resources, labor relations and corporate governance. The usual suspects of alcohol, gaming and tobacco do not make the cut. Managers then actively weight those stocks within the portfolio to replicate the returns of the index, which tracks the 3,000 largest U.S. companies. Over the past five years, the fund returned an annualized 2.5%, beating its benchmark as well as the S&P 500 by an average of one percentage point per year.
With a 0.61% expense ratio, Social Choice Equity is not the cheapest socially screened index fund. Vanguard FTSE Social Index, which charges 0.29%, claims that title. However, in December 2005 Vanguard changed the socially screened index it sought to replicate from the Calvert Social index to the FTSE4Good U.S. Select index, and over the past five years the fund has lagged the S&P 500 by an average of one percentage point per year.
Going the ETF route
The choices among socially screened ETFs offer limited opportunities. Most of the funds track indexes that are too narrow to give your portfolio adequate diversification. But iShares KLD Select Social (KLD), which charges 0.50% annually, is worth a look. It moves almost completely in sync with the S&P 500, even though energy, utility and media stocks are underrepresented in the fund. Over the past five years, KLD returned an annualized 1.1%, beating the S&P 500 by an average of 0.1 percentage point per year.
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