NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning.
What are Socially Responsible Mutual Funds? (also known as Socially Responsible Investing - SRI)
Socially Responsible Mutual Funds often invest in companies that pay attention to things like....
Ethics
Human Rights
Environment
Product Safety
Or, they avoid companies that invest in....
Gambling
Tobacco
Alcohol
Weapons
I have been telling people for years that Socially Responsible Mutual Funds are a bad choice but, as a good skeptic, I have to double check. I have to make sure I just don't look for evidence that confirms my view I have to look for evidence that confronts my position and evaluate it. I begin with a Google search and found a very positive story about Socially Responsible mutual funds from Kiplinger.
The author tells us that it is a growing business.
In 1995, there were only 55 mutual funds that engaged in SRI, with $12 billion in assets. Now there are 493, with assets of $569 billion.
That is amazing growth but, is it an appeal to popularity. Maybe it is just the result of good marketing. I need to know more about how these funds work.
Unfortunately, There is also a serious problem in defining what can be bought in Socially Responsible mutual funds. Each fund is different and has different rules. Some say you can't buy stock in Apple because in uses kids in low income countries others say you should by Apple because it helps people in low income countries. I found this in the Kiplinger story....
Lately, some of the largest SRI funds have been straying from their dogma and injecting more subjective judgment into their decision-making. Or maybe they’re just hedging their bets. For instance, the Web site of Domini Social Equity (DSEFX), founded in 1991, contains this disclaimer: “Domini may determine that a security is eligible for investment even if a corporation’s profile reflects a mixture of positive and negative social and environmental characteristics.”
Huh? So, they can invest in anything? What is the point. You may find another fund that invests in what you wanc but, they can change later - after they have your money. You cannot control what they buy.
The Kiplinger's story featured a few of the best Socially Responsible Mutual Funds (and ETFs) and looked at their results. Unfortunately, they used different time periods (sometimes 5 years sometimes 15 years) when looking at the different options and I did not like that they kept comparing results to the S&P 500 index. The S&P 500 is only large companies and for the last 10 years it has slightly lagged the whole market. I think a better comparison is the Wilshire 5000 index.
Some of the funds Kiplinger mentioned have loads (an extra fee you pay to buy) of around 5% and one required an initial investment of $1,000,000. (note: Kiplinger did not reduce returns to account for the load.)
Let's look at their first example....
Consider iShares MSCI USA ESG Select Index (symbol KLD), an exchange-traded fund
that tracks an index of companies that it says follow high “environmental, social and governance” standards. Over the past five years, the fund returned an annualized 2.3%, compared with 1.7% for Standard & Poor’s 500-stock index.
I realized that this story was published in May of 2012 (2.5 years ago) and those 5 years included the horrible year of 2008. I was curious, how did this investment do since then? From June 1, 2012 to Oct 29, 2014 KLD returned 44.43% and the S&P 500 Index returned 52.64% (NOTE the Wilshire 5000 was up 53.03%). KLD under performed by more than 8% - ouch. Remember what they always say, "Past performance is not necessarily indicative of future results".
I decided to take a bigger look and found a good basket of Socially Responsible mutual funds. I used the site Socialfunds.com to help me find some of these funds. I only wanted to look at funds that had a 10 year track record (ending June 30, 2014) and invested just in the US stock market. Here is what I found....
Fund Name 10 Year Average
TIAA-CREF Social Choice Equity Fund
7.90
Calvert Social Index
6.41
Domini Social Equity
6.63
Walden Equity
7.08
Ariel Funds
7.18
Dreyfus Third Century C
6.38
Green Century Equity
6.19
Legg - Mason Social Aware C
4.79
Parnassus Fund
9.78
Sentinal Sustainable Core A
6.89
Vanguard FTSE Social Index
6.46
Walden Social Equity Fund
7.08
The overall performance of these funds was 6.90% per year. The Wilshire 5000 was 8.50% per year. The under performance is about 1.6% per year. This is about the same result for mutual funds as a whole. This is one of the many reasons I recommend Index Funds. You may have noticed that one fund (Parnassus) did better than the market. 1 out of 12! There is no reason to think this is anything but chance.
Why do these funds do so poorly? An important factor is costs....(via Investopedia)
Socially responsible mutual funds tend to have higher fees than regular funds. These higher fees can be attributed to the additional ethical research that mutual fund managers must undertake. In addition, socially responsible funds tend to be managed by smaller mutual fund companies and the assets under management are relatively small.
The final problem with Socially Responsible Mutual Funds is that you are not actually helping.
Let me explain....
When you (or the mutual fund) buy a stock, you buy it from someone that already owns the stock. NO money goes to the company. This does not apply to IPOs (Initial Public Offerings). With an IPO the money goes directly to the company but, the IPO price is set in advance and any increase in demand does not directly benefit the company (unless the company can't sell all of the shares). You could argue that the increased demand in a specific (socially responsible) stock could increase the price and provide a benefit to the CEO or other big investors. This is also unlikely because there are other investors that will sell shares if they think the stock's price has gone up beyond the perceived value of the company.
In summary we have these problems...
1) You can't know for sure if the funds do (or will do) what you want.
2) You will likely under perform the market by 1.6%
3) You are not actually doing any good.
The solution....
Invest in index funds and take 1.6% out each year and give it to the charity of your choice! You will have control over the money and you will know that you are making a difference. Everybody wins!