DEFINING SRI

SRI has been referred to as “double-bottom-line” investing. The implication is that investments must not only be profitable, but must also meet investors’ personal standards. Some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages, or weapons, or that rely on animal testing as part of their research and development efforts. Other investors may also be concerned about social, environmental, governance, labor, or religious issues. It is important to note that SRI encompasses many personal beliefs and does not reflect just one set of values. Therefore, it is no surprise that each socially responsible fund relies on its own carefully developed “screening” system.

For example, consider the “gay benefits” issue. Some funds specifically exclude companies like Walt Disney for maintaining gay-friendly employee benefits policies. On the other hand, the Meyers Pride Value Fund (which merged into the Citizen’s Value Fund in September 2001) only invested in companies that offered domestic partner benefits and supported policies that prohibited discrimination against homosexuals.

There are also funds designed for Catholics (Ave Maria Mutual Funds), Muslims (Amana Mutual Funds Trust), Presbyterians (New Covenant Funds) and Christians of all faiths (the Timothy Plan). Our capitalist system excels at responding to the growing demand for customized approaches to investing.

RAPID GROWTH

TIAA-CREF began offering a socially responsible fund in 1990. Since then, assets dedicated to SRI have grown rapidly. According to the Social Investment Forum, total SRI assets in the United States rose from $639 billion in 1995 to $2.71 trillion in 2007, which represents 11 percent of the total assets under professional management tracked in Nelson Information’s Directory of Investment Managers.

While institutions, with $1.9 trillion in assets, are clearly the largest participants in the SRI market, mutual funds dedicated to SRI have exploded in popularity, growing from $12 billion in assets in 1995 to $202 billion in 2007, far outpacing overall mutual funds growth nationwide.¹

Investors even have a choice between active and passive (index) strategies. In the case of the socially responsible index funds, the management of the fund designates its own index. For example, the Domini Social Equity Fund, one of the largest SRI funds, with $892 million of assets under management as of April 2008, originally relied on an index of four hundred socially acceptable stocks (as compared to the S&P 500 Index). Unfortunately, given the historical evidence on the poor and inconsistent performance of actively managed funds, the fund received shareholder approval to switch to an active approach as of November 30, 2006. The fund also has a high expense ratio of 1.08 percent.

One passive alternative is the Calvert Social Index Fund. As of March 2008, the fund had $84 million in assets under management and held 636 issues. The Class A shares of the fund have an expense ratio of 0.75 percent. Unfortunately, they also carry a 4.75 percent load. Additionally, the minimum investment is $5,000.

DOES SOCIALLY RESPONSIBLE INVESTING COME AT A PRICE?

Thanks to the 2003 study “Investing in Socially Responsible Mutual Funds,” by Christopher C. Geczy, Robert F. Stambaugh, and David Levin, we now know that SRI does come at a price.² But just how large a price one pays for social responsibility depends on how investors allocate their equity investments to various equity asset classes.

The study focused on thirty-four no-load equity funds that could provide at least three years of data on returns, expenses, and turnover. The sample and its subsets were large enough to represent the socially responsible universe in a meaningful way. The authors came to the following conclusions:

1. Passive investors pay a price of about 0.5 percent per year when investing in socially responsible broad-market index funds. Socially responsible funds have higher costs because of the cost of developing and implementing the screens. The Domini Social Equity Fund’s expense ratio (1.08 percent) is much higher than the expense ratio of a low-cost S&P 500 fund or an exchange-traded fund (ETF). Naturally, higher costs translate into lower returns.

The returns of one of the most popular SRI funds offer compelling evidence. For the period from 2003 through 2007, the Domini Social Equity Fund returned 10.1 percent per year, compared to a gain of 12.7 percent for the Vanguard 500 Index Fund. Thus, we can say, at least in this case, “the cost of being socially responsible” was actually 2.6 percent per year.

Historically, small-cap and value stocks have provided risk premiums over large-cap and growth stocks. Most socially responsible funds are large-cap funds that tend to have a growth orientation based on their screening process. Thus, socially responsible investors who would otherwise prefer to gain exposure to small-cap and value stocks sacrifice higher expected returns. Additionally, they lose out on the diversification benefits of allocating portions of their portfolio to those two asset classes. The study found that for these investors the cost of being socially responsible rose to as much as about 3.5 percent per year, depending on the amount of exposure the investor opted for in the riskiest asset class (small-cap value).

2. Socially responsible investors also may be accepting other risks. Because the funds are not fully diversified (that is, they generally screen out what are known as “sin” stocks), they are taking uncompensated risk—risk that can be diversified away. Accepting this risk increases volatility and the dispersion of returns.

In the case of broad market indexes, this problem is relatively minor. For example, according to Morningstar Principia, as of February 2008 the Calvert Social Index Fund held 636 stocks, providing significant diversification. However, it is basically a large-cap growth fund. The problems related to this situation are magnified when investors seek to invest in other asset classes, such as small-cap value.

It should be noted, for instance, that we could not identify any socially responsible funds that invest in international small-cap or value stocks, or any real estate-based SRI funds. However, in August 2006, Dimensional Fund Advisors (DFA) opened the first socially responsible emerging market fund— the Emerging Markets Social Core Equity Portfolio. The bottom line is that investors who do not invest in anything but SRI vehicles are likely to be missing out on important diversification benefits.

THE “PRICE” OF PRINCIPLES

One way to look at the relative underperformance of the Domini fund, and SRI funds in general, is that it represents the price of investing according to your principles. Some might conclude that the cost is worth it, while some might decide that the cost is too great. Another alternative is to consider how that same performance differential could be used to support personal beliefs or values.

For example, investors could invest in the aforementioned Vanguard funds instead of the Domini fund and donate the difference in returns to their favorite charitable causes. They could also increase their allocation to other asset classes with higher expected returns, and further diversify the risk of their portfolio. Doing so would provide two distinct benefits. The first is a tax deduction for the donation. And if donating appreciated shares, capital gains taxes are avoided. The second benefit is that the choice of causes is now completely in the investors’ hands.

Obviously, this is a personal decision and one for which there is no single, right answer. The goal of this book is to ensure that investors consider all the issues and alternative strategies, as well as their implications.

SUMMARY

Investors who want to “do good” by investing in socially responsible funds should recognize that they are likely paying a considerable price in the form of lower expected returns. These lower expected returns should not come as a surprise, because in addition to the higher fees that reduce returns, the demand for SRI drives up the stock prices of companies that pass social screens. This lowers the cost of capital for these firms. The flip side of a lower cost of capital is a lower expected return to investors.

The reverse is true for companies that fail to pass through the screens. Their cost of capital increases. Thus, their investors now have a higher expected return. In addition to accepting lower expected returns, socially responsible investors should remember that they are also accepting somewhat greater portfolio risk due to inefficient diversification.

The cost of SRI, in the form of lower expected returns, should be weighed against the value placed on the desire to be socially responsible. Those interested in SRI can find a current list of socially responsible mutual funds at www.socialinvest.org. This list includes both domestic and international funds, as well as both equity and bond funds.