About five years ago, when accounting scandals were roiling stock markets, promoters of socially responsible investments (SRI) trumpeted their social-screening criteria as effective tools to keep bad apples – and big losses – out of one's portfolio.
Now jittery stock markets, spooked in recent weeks by two of the biggest single-day dips in years, suggest that some investors could use a steady keel in their portfolios. Among the top issues is whether ethical investments can be a haven from an imploding subprime mortgage market and its ripple effects.
But history suggests that SRI mutual funds have been no panacea for avoiding a bumpy road. And if the financial sector stumbles, as some analysts predict, then short-term results this time around are apt to depend largely on whether screens used by particular SRI funds have served to lessen or heighten related risks.
In a March analysis of the most volatile market years of the past two decades, fund tracker Morningstar found that SRI investors tend to feel the pain of plunging markets even more than other investors do. Plus, when fluctuating prices have led to big gains, SRI funds have missed part of the party. Consider:
•When the stock market struggled in 1987 and 1990, SRI funds trailed the benchmark S&P 500 index by more than three percentage points in each year.
•In the volatile heyday of the technology boom in 1998 and 1999, SRI funds posted gains that fell 10 and two percentage points below the S&P's in respective years.
•Even in 2002, when terrorism fears and corporate scandals dragged the market down, SRI funds overall lost 23.2 percent of their value while the S&P 500 lost 22.1 percent.
Despite these findings, ethically driven strategies have at times paid off for investors. KLD Research & Analytics' benchmark Domini 400 Social Index, for instance, has since its inception in 1990 outperformed the S&P 500 in cumulative and annualized returns. But investors guided by that index have had a wild ride. Over 17 years, the index has been 6.35 percent more volatile than the S&P, which points to more price fluctuation in the portfolios of investors, according to KLD Business Development Manager Chris McKnett.
Conclusion: SRI funds are usually not a haven in volatile periods. As a result, ethically minded investors need a long-term horizon, say industry veterans. It also means they need to consider whether the funds they own are positioned to prosper or flounder as a result of current trends.
"There is more volatility generally in a socially conscious portfolio than in a portfolio that's more equally weighted across all market sectors," says Steve Scheuth, president of First Affirmative Financial Network, a Colorado Springs, Colo., money-management firm with an SRI focus. "What that means is that in certain market environments we do better [than other investors]. And in certain market environments, we don't do so well."
Volatility refers to the degree of movement in stock prices – up, down, or both. When stock prices on average are rising or falling 1.5 percent more than they normally do on a benchmark index, such as the S&P 500, then a period is especially volatile. In the past two decades, the most volatile times have occurred during the early stages of recessions as well as during lofty bull runs.
Steady growth has characterized stock markets over the past four years, and it's too early to tell whether that trend is finished. Investors have displayed signs of nervousness in the past month, however. The most recent sell-off came March 13 in the wake of news that lenders specializing in subprime mortgages, which charge high interest rates over time and levy hefty fees for noncompliance, faced mounting defaults and were tightening controls.
How ethical investors should approach subprime lending is a matter of debate. Some activists believe the practice is not only risky for investors but is also a moral scourge because it sets up the vulnerable to fail.
"To the extent that wealth has been created [in African-American households], it's been through home ownership and the equity appreciation obtained through a mortgage," says Eric Stein, senior vice president of the Center for Responsible Lending, a nonprofit that fights predatory lending. "The explosion in the subprime mortgage market – [which] has developed over the last four years – has been, I think, the largest threat to that wealth in American history, aside from slavery."
Some in SRI made a point to steer clear of sub-prime lenders. KLD's Domini 400 Social Index, for instance, delisted Household Finance back in December 2002 after the company settled a predatory lending case brought by multiple states, according to Director of Research Eric Fernald. SRI funds using that index as a guide would probably not own certain firms that are players in the sub-prime market. And those that aren't vigilant about screening out subprime lenders should become more so, says Doug Wheat, a Northampton, Mass., financial adviser with an SRI specialty.
"It is both a moral and financial risk issue" for SRI investors, Mr. Wheat says. "If the mutual funds aren't active in screening out [predatory lending], they should encourage the mutual funds to change their practice."
But some SRI funds give the entire finance industry a wide berth. Those with an environmental emphasis often load up on financial institutions in their portfolios because theirs is largely a nonpolluting industry. The Vanguard FTSE Social Index, for instance, has 40 percent of its holdings in financials. The Sierra Club Stock Fund has a 30 percent exposure to financials, more than any other sector in its portfolio. Although the Sierra Club Stock Fund screens out firms cited for deceptive practices, it allows for subprime lending and includes two of the nation's largest players in that market: Wells Fargo and Countrywide Financial.
"The subprime market in itself does not equal predatory and in fact can be beneficial," says Garvin Jabusch, portfolio manager for the Sierra Club Stock Fund. "In a lot of cases, if there isn't a subprime lender, some people with questionable credit are never going to own a home. We actually think that a responsible subprime lender is socially valuable."
Mr. Jabusch concedes that a heavy weighting in financials increases risk due to lack of diversification, but he says the strategy also reduces volatility in certain circumstances. Specifically he argues that because the Sierra Club fund steers clear of oil producers and fossil fuel-burning utilities, it provides stability when energy markets are volatile. When energy slumped in 2003, he notes, the fund outperformed the S&P by 6 percent. Conversely in 2006, when oil enjoyed strong growth, the fund lagged 5 percent behind the S&P.
SRI boosters insist that social screens do, at important times, ferret out particular risks responsible for a market downturn. A classic example occurred in 2002, according to Julie Gorte, vice president and chief social investment strategist at Calvert Funds. Sensitive to lawsuits, citations, and other warning signs of unscrupulous management, Calvert's Social Equity Fund had by 2002 already weeded out many firms that would suffer scandals and drag down other funds' portfolios, including Tyco, WorldCom, and Rite Aid.
As a result, Ms. Gorte says, the fund ended the year down just 14.9 percent while the S&P lost 22.1 percent.
Ultimately, risk-averse investors with an ethical bent and a short-term horizon need to judge whether particular funds have the right screens in place to mitigate factors that are apt to hamper stock prices in the near future.
Those who aren't satisfied with their current position have options, according to Mr. Scheuth, such as taking shelter in a socially screened bond fund. And for those who prefer to see money in the bank during periods of uncertainty, he recommends community development banks that have social missions and competitive rates on certificates of deposit (CDs).