Socially responsible investing (SRI) has always had to fight the perception that it may be better for your soul than for your bottom line. Most investment professionals will agree in principle that adding social criteria on top of the things that investors normally consider when selecting stocks--company fundamentals and stock valuation--restricts one's investable universe in ways that are unlikely to improve returns.
If, for example, you started out with a universe of 100 stocks, and your social screens disqualified 20 of them, you'd have only 80 choices available to try to outperform the market and other active investors who have the entire 100 stocks at their disposal. The conventional wisdom might be different if social criteria effectively screened out the worst-performing stocks, but a lack of social graces is not necessarily an impediment to a company's stock price. Academics studying the link between commonly used social criteria and stock performance haven't found a clear-cut relationship, positive or negative.
Two years ago, when we took a look at the universe of socially conscious mutual funds, not a single SRI fund merited a 5-star rating.
A lot can change in two years.
Today, 21% of the SRI funds in our database that have the necessary three-year record sport a 5-star rating. That's twice the rate of the overall fund universe. Moreover, only 19% of SRI funds find themselves in 2-star or 1-star territory, while a third of the overall fund universe rates that low.
SRI funds stack up even better when they are compared to their specific Morningstar categories. One quarter of these funds currently sport a top category rating of 5, and half have category ratings of 4 or 5.
The smaller group of SRI funds that have a five-year record (35 in all) is less impressive, though still acceptable. A total of 19 have outperformed their category peers over the trailing five years while 16 underperformed.
That doesn't mean social screens add value, but it's hard to make the case that they subtract it.
What happened? Have SRI funds discovered some magic formula for investing that didn't exist before? Not really. Few, if any, funds have made notable changes in their screening practices over the past couple of years.
But screening certainly has something to do with SRI funds' recent performance. Screening out tobacco companies and nuclear power utilities has kept the funds away from some of the market's worst performers over the past few years. Avoiding these and other firms with poor environmental records leaves the typical SRI domestic-equity fund underweighted in value stocks and overweighted in growth stocks. Indeed, in the SRI arena growth funds outnumber value funds 14 to 5. Most SRI domestic-equity funds are also large-cap offerings.
That proved to be a potent combination in 1997 and 1998 when large-growth stocks fueled the stock market's rise. Of the 14 funds that came of age between October 1997 (the date of our earlier study) and August 1999, eight had significant exposure to large-growth stocks and seven of those funds garnered 5-star ratings. Two older funds improved to five stars for the same reason.
That's not the entire explanation, though. The large-growth tilt helps explain SRI funds' improved star ratings, but not their improved category ratings. Lots of large-blend and large-growth funds sport 5-star ratings because they are being favorably compared with smaller-cap offerings, but SRI funds still do well when we compare apples to apples (i.e., compare funds in the same style-box-based Morningstar category).
Some of this success owes to the impact of two socially screened indexes, which together are tracked by six of the top-rated funds. The Domini Social index and the Citizens index have prospered for the same basic reason that the S&P 500 index has over the past couple of years: The stocks at the top of these capitalization-weighted indexes were those that led the market's rise.
Domini Social Equity DSEFX and its institutional fund both have category ratings of 5, as do two other funds based on the Domini Social index--Green Century Equity GCEQX and Devcap Shared Return DESRX. Both share classes of Citizens Index Fund WAIDX have recently passed their third anniversaries and now sport top category marks. In all, about half of SRI funds that have category ratings of 5 are indexed offerings.
Even accounting for the index effect and the large-growth bias, though, SRI funds remain skewed toward the top of the category ratings. If we throw out the large-growth and large-blend offerings, half of the remaining SRI funds have category ratings of 4 or 5 (multiple share classes excluded). SRI offerings boast top category ratings in seven different categories.
With that many top performers in the SRI-fund stable, it's a relatively easy task for social investors to pick out a good fund or two. But is it possible for social investors to build a well-diversified portfolio consisting solely of socially screened funds? It's one thing to show concern about social issues by dropping a few bucks in a single fund, but quite another to put an entire nest egg into social funds.
For those committed to the concept, we think a broad portfolio can be built--but just barely, and only for a certain type of social investor. For one thing, few socially screened funds have really proven themselves over long time periods. Of the nine funds with 10-year records, only Dreyfus Third Century DRTHX (large-growth) and Pax World PAXWX (domestic hybrid) have 4- or 5-star ratings. For another, there aren't a lot of choices in many investment categories, particularly fixed-income, international, and value-oriented domestic equity. Socially screened funds can also be expensive. The typical SRI fund charges 15% more than its average category peer. Apparently, many SRI funds' sense of social responsibility doesn't extend to how much they charge their shareholders.
And last, but certainly not least, SRI funds do not all follow the same social investment policies. Social funds don't all use exactly the same screens, don't all engage in the same level of shareholder activism, and don't all aim to have a high social impact. Moreover, the term "socially responsible" encompasses two groups of funds: religious and non-religious.
Religious offerings such as Amana Growth AMAGX (an Islamic fund) and Timothy Plan TIMBX (a conservative Christian fund) screen out stocks that violate particular religious tenets, and such screens vary considerably from fund family to fund family. Many nonreligious funds, on the other hand, share similar screens (although they are not the same by any means). Offerings such as Domini Social Equity and Calvert Social Investment Fund Balanced CSIFX search for companies with strong records on environmental, diversity, and workplace issues. These same funds also tend to exclude alcohol, tobacco, and weapons makers and many also reject nuclear power companies.
With these caveats in mind, though, it is possible to select a quality portfolio of nonreligious SRI funds. (The same is not true of the religious funds. While there are a number of religious funds available--and some have good track records--there isn't a broad enough array to assemble a diversified portfolio of funds that adequately accommodates a particular religious persuasion.) We make one effort below, by highlighting some of the better secular SRI offerings in each asset class--domestic equity, international equity, and fixed-income.
Domini Social Equity is a passively managed fund that tracks the Domini Social index. All stocks in the index have passed a series of positive and negative screens, and the final result is a list of 400 companies--approximately 250 from the S&P 500 and another 150 large- and mid-cap non-S&P 500 firms. Like many socially responsible funds, Domini Social Equity has a growth tilt, although the fund still manages to land consistently in the large-blend column of the style box. That fondness for growth stocks has helped this fund to a superb record: Its three- and five-year returns best the S&P 500 index. Domini's shareholder activism gives the fund added appeal. A great core holding.
Alternative: Like Domini, Citizens Index is a large-cap fund, but it contains even more growth names than its rival. Citizens' record is very good, but its 1.59% expense ratio is frustratingly high for an index fund.
Ariel Appreciation CAAPX is a solid fund that provides some much-needed diversification to a socially conscious portfolio. Manager Erik McKissack looks for undervalued stocks and finds a lot of his favorites in financials, services, and industrial cyclicals. He doesn't invest much in technology, making this offering a nice counterweight to the tech-heavy portfolios of most other SRI offerings. The fund also holds a healthy dose of small caps. McKissack runs a concentrated portfolio, though, which can lead to the occasional rough spot, as this year's lackluster performance demonstrates. Ariel isn't as aggressive in its social screening as many of its SRI peers.
Alternative: At Neuberger Berman Socially Responsive NBSRX, another value-oriented fund, manager Janet Prindle does her social screening a little differently than most. Rather than avoiding entire industries, she looks for the companies in each sector with the best environmental and workplace records that also meet her financial criteria. Thus, this fund owns more industrial-cyclical names than many of its SRI peers. A solid record adds to the appeal.
Citizens Emerging Growth WAEGX is an actively managed fund with a lot of oomph. Manager Richard Little's earnings-momentum approach, along with a concentrated portfolio and a huge technology stake (currently 40% of assets), has delivered strong returns. Such aggressive traits will inevitably lead to volatility, though. Unfortunately, the fund shares a family trait with Citizens Index: an unpalatably high expense ratio. On the plus side, the fund uses extensive positive and negative social screens.
Alternative: Calvert Capital Accumulation CCAFX has a less stellar--but recently improved--record, and it's not as risky as Citizens Emerging Growth. Calvert's social screens are wide-ranging, but its expenses are also high.
Calvert Social Investment Bond CSIBX is a straightforward fixed-income choice. It invests mostly in mortgages and mid- to high-quality corporate bonds. Just as with its stock funds, Calvert avoids bonds issued by firms that fail their screens. For example, management eschews companies with poor environmental and workplace records. Moreover, manager Greg Habeeb doesn't buy Treasuries because their proceeds could finance government defense spending. The fund's long-term record is respectable, and it has a category rating of 4.
Here, social investors have to settle for average. Calvert World Values International Equity CWVGX is one of the few socially screened international funds available, and the only one with a three-year record. Manager Andrew Preston looks for cheap stocks within undervalued markets. The fund lands in the middle third of the foreign-stock group.
Alternative: Citizens Global Equity WAGEX has an outstanding record, but it's a world-stock fund with a third of assets in the United States, so its doesn't provide the diversification of an all-foreign fund. Like other Citizens funds it has a high expense ratio