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Sizing Up Socially Responsible Funds

The pros and cons of values-based investing.

Advocates of socially responsible investing (SRI) sometimes draw connections between social screening and investment performance. In theory anyway, the connection seems tenable. If a company's business model relies on environmentally destructive behavior, say, or the sale of stigmatized or heavily regulated products such as tobacco or firearms, it seems reasonable to think those practices might eventually ding the bottom line. Conversely, goes the argument, firms that steer clear of such verboten products or practices will likely make the superior investment--as will the mutual funds that invest in them.

But is this line of reasoning borne out by the evidence? Not exactly.

Consider the case of Philip Morris, which now goes by the name  Altria Group  (MO). Though heavily exposed to tobacco litigation, the firm still managed to generate $10.6 billion in free cash flow last year. And, relatively unhindered by the social stigma that attaches to cigarettes in the United States, the company's global operation continues to ramp up sales and profits. Considered in purely financial (as opposed to social) terms, therefore, Altria looks like a pretty good investment.

Some SRI proponents have also argued that corporate-governance screens would help the funds that employ them steer clear of Enron-type fraud. But that’s not the main focus of most of these funds, and, at any rate, SRI funds have held their share of accounting disasters.

But social screens aren't detrimental to performance, either. We recently surveyed our database of SRI funds and found that the returns of funds that practice social screening are roughly comparable to plain-vanilla offerings. Moreover, looking at domestic-equity funds, we see normal distributions of performance and star ratings--average performance, in other words, which would indicate that SRI screens don't have a big impact on returns.

That doesn't make values-based investing a bad idea, however. After all, the main goals of SRI funds are to have a positive impact on corporate behavior and to enable people to invest in businesses they're comfortable owning. So, a fund with social screens that also has the important fundamentals you want in any fund--a sound strategy, low costs, and good management--ought to do a fine job of helping investors reach their goals

But there is one area where SRI funds need work. For the trailing five-year period ended May 2003, the typical SRI domestic-equity offering docked shareholders nearly 20 basis points more each year in expenses than the average non-SRI entrant.

As savvy fund investors know, that difference puts SRI funds at a distinct disadvantage. The performance of any mutual fund will vary over time, but the ill effects of a hefty price tag are a bit like death and taxes. They're depressingly reliable, a consistent drag on returns that erodes gains over time and makes it very difficult--if not impossible--for pricier offerings to stay competitive with less-expensive fare. Moreover, though the expense gap between SRI and non-SRI funds appears to be narrowing, it still persists.

Which raises a vexing question: Are socially responsible investors investing responsibly? That is, given that fees are such a key determinant of future returns, are shareholders doing the right thing--investment-wise--by paying up for a mutual fund when cheaper options are available?

Comparison Shopping
We don't think so, especially when, even within the relatively small universe of SRI funds, there are plenty of appealing picks. After all, even though SRI offerings on average cost more, investors don't have to buy the average fund. For those who are so inclined, in fact, it's possible to assemble a reasonably well-diversified portfolio of just SRI funds with relatively low price tags and whose performance has bested that of average peers over time.

Next month, Morningstar will roll out a seminar, "Profiting with Socially Responsible Funds," that will teach participants how to do just that. (Enrollment opens Aug. 27; classes begin Sept. 25. Visit and bookmark's Learning Center to get the latest seminar news.)  For now, we'll note that, just as among non-SRI funds, a strong correlation exists in the SRI universe between fees and performance. Indeed, each of the five least-expensive SRI offerings has outperformed its respective peer group for the trailing three-year period ended July 2003.

Finally, potential SRI investors should know that the universe of values-based mutual funds has grown tremendously over the last 20 years or so. The SRI industry now offers a wide range of investment styles and, of course, social screens. Secular-oriented fund shops such as Calvert and Domini run the lion's share of the industry's assets under management and generally filter out firms that derive revenue from such things as weapons manufacturing or those that operate nuclear power plants. Tobacco or alcohol-related companies are frequently excluded, too.

Religious investors also have SRI options. The successful  Amana Mutual Funds Trust Growth Fund (AMAGX), for instance, is an Islamic-oriented fund that, among other things, refuses to invest in companies that earn more than 5% of their revenue from gambling, pork processing, or money lending.

We'll explore both flavors of SRI investing in our seminar this fall. See you in class.

Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.