Ethical investments: A shelter from the stock market's storms?

"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).

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