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Feel-good investing? I'd rather make money
I'd prefer my mutual funds generate fat returns, leaving me plenty of dough to contribute to charity, than sacrifice half my profits in the name of so-called social responsibility.
By Timothy Middleton
I've written several times about mutual funds that call themselves socially responsible, arguing investors would be better off investing in traditional funds and then supporting favored causes with their checks. I always attract critics who assert these funds are just as good as other funds.
Well, they aren't.
A pair of finance professors at the Wharton School subjected this anti-sin, pro-labor universe of funds to critical analysis, and their findings are shocking. Because of high costs and generally weak management, these funds underperform conventional funds by "at least 3.5% a year," says Christopher Geczy, a co-author of the study. If you expect, as Warren Buffett does, that stock returns will average 7% in coming years, that 3.5% would equal half of everything you make.
Some investors are willing to pay this usurious price: Geczy says he cant measure the feel-good utility of such funds, but it's high. Also, his research indicates investors who style themselves progressives put only about a third of their assets into such funds, so their net sacrifice is much less, only about 15% of total returns.
Socially responsible investors also can cut their losses by choosing index funds over actively managed funds; there, the slippage is only about 11 cents on the dollar, or 4 cents if you yourself are irresponsible with two-thirds of your money.
High expenses + no star managers = lackluster returns
The Wharton study, titled "Investing in Socially Responsible Mutual Funds," was written by Geczy, Robert Stambaugh, also a finance professor, and David Levin, a graduate student. It hasnt yet been published, but can be read at the Wharton Web site by using the link at left under Related Sites.
It covers the period 1963 through 2001, during the latter part of which socially responsible investing has really taken off. The authors say it accounted for $2.34 trillion at the end of 2001, roughly $1 of every $8 that was professionally managed then. Assets grew 36% between 1999 and 2001, sharply more than the 22% gain of professional managers in general. But most of this money, $1.87 trillion of it, is invested in pensions and other private portfolios rather than mutual funds.
The study analyzed funds because more data about them are available. It did so chiefly using the capital-asset-pricing model, which helped win William Sharpe a Nobel Prize in economics and led to the Sharpe ratio, a measure of returns adjusted for the risks they take. Multiple domestic-equity funds were combined to create those with the highest Sharpe ratio. The data were drawn from the University of Chicagos Center for Research in Security Prices database and included 849 funds with performance records of at least three years, 50 of which screen out investments in liquor, tobacco, gambling, nuclear power, defense and, in the case of religious funds, drug companies that make abortion pills and supplies.
The study found that funds that employ socially conscious criteria cost their investors 0.3% a month, which with compounding is actually 4.3 percentage points a year.
The study lays the blame for the underperformance of socially responsible funds at two doors. One is that average annual expense ratios of these funds are substantially higher than those of others, about 1.3% a year compared with 1.1%. The authors assume these costs result from the added research managers conduct to find companies they deem to be socially conscious.
The other, which accounts for the disparity between indexed and managed funds, is that active socially responsible managers simply dont perform as well as the best fund managers who pick from the broader spectrum. None of them has the kind of spectacular record that the conventional fund universe tosses up regularly.
The problem is not so much that socially responsible managers are mediocre as that the field is bereft of superstars. Outside of socially responsible investing, superstars pull up the average for everybody else. You can boost your portfolio with superstar funds. But socially responsible investors can't because they dont have any from which to choose.
Costly convictions
All of these factors argue that investors who feel drawn to socially responsible funds recognize that their convictions are going to cost them. Sales pitches arguing that social screening produces superior investments are bunk.
The return of Vanguard 500 Index (VFINX) over the last 10 years, of 9.97%, significantly outpaces the 9.53% delivered by Domini Social Equity (DSEFX), primarily because of the latters 0.92% expense ratio, which is, dare I say, irresponsibly high for an index fund. Vanguard does it for 0.18%.
I confess to a fundamental prejudice against things that call themselves something they aren't. Pro-life falsely posits that the pro-abortion crowd is inhuman, and socially responsible falsely posits that everyone else is inhumane. For that matter, what's so socially responsible about Enron, which was one of the category's favorite stocks before it collapsed?
Personally, I prefer investments that deliver superior results, which allow me to write checks to my favorite causes privately. As the Rodney Dangerfield character said in the movie "Caddyshack," You want satisfaction? How about cash? Thats very satisfying!
A different approach
How about a portfolio manager responsible to his investors rather than political correctness? That would be John Montgomery of the small Bridgeway family of mutual funds.
All of them have outstanding performance records and reasonable fees, and many are closed to new investors because he focuses mostly on small companies. Montgomery limits his salary to a fraction of the industry standard and gives half his profits to charity. While Montgomery belongs to the Social Investment Forum, Bridgeway funds aren't socially responsible, and the one such fund Montgomery manages as a sub-adviser, Calvert Large Cap Growth (CLGAX), has a front-end load, high expenses and a mediocre performance record.
Don Yacktman is a Mormon who doesnt even swear or drink iced tea. Yacktman Fund (YACKX) ranks No. 1 in the midcap value category over the last three years. Unfortunately for ideologues, Yacktman checks his personal beliefs at the door; his 24th largest holding is Altria Group (MO, news, msgs), the old Philip Morris, which he has owned forever and once described to me as an ATM machine you dont need a card for.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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