More ETFs aim to please the socially minded
Two new exchange traded funds are geared toward alternative energy firms and pressuring for reform in Sudan.
Chicago management consultant Kenneth O'Hare knows from experience that the stocks of "green" energy companies can rise and fall just like the winds and tides that he regards as the future of power.
Even so, he plows $500 per month into alternative energy investments and still manages to sleep well at night. His secret: exchange traded funds (ETFs) have relieved his prior burden of picking stocks in a sometimes tumultuous sector where few mutual funds dare to tread.
"I was in effect trying to manage my own mutual fund, and I realized that it was beyond me," Mr. O'Hare says. His ETFs "represent a basket of companies in a field that I'm interested in," yet they don't require him to "do a great deal of research on each company."
The financial world's highly popular ETF products resemble mutual funds in that they consist of stocks of multiple companies, but they differ in that they trade like stocks on an exchange. That means the market value of these cheap-to-maintain investments changes all day long, sometimes for better and sometimes for worse.
For ethically minded investors, the fast proliferation of ETFs in recent years has put powerful new tools in their wealth-building, world-improving toolboxes. Over the past 2-1/2 years, at least a dozen ETFs with a socially responsible angle have appeared in the marketplace. Two just launched in June: PowerShares Global Clean Energy Portfolio and the Claymore/KLD Sudan Free Large Cap Core ETF. The latter shuns companies with ties to Sudan, where the government stands accused of sponsoring terrorism and sanctioning genocide in the Darfur region.
Socially responsible ETFs still represent just a sliver of the total ETF universe, which includes more than 560 unique products, but they are nonetheless shaping in important ways the portfolios of discerning investors.
The most basic appeal of ETFs, for investors with and without social missions, is their relatively low maintenance costs. ETF investors generally give up just 0.5 percent of their asset value per annum for operating expenses, versus an average of 1.2 percent for an actively managed mutual fund. That's largely because ETFs have no manager getting paid to decide whether a particular stock is poised to pop or fizzle. As a result, ETFs cost less than managed funds do to operate.
Comparing ETFs with an actively managed mutual fund, "the lone disadvantage [of ETFs] would be if the actively managed fund consistently outperforms the socially responsible ETFs over time," says an e-mail from Tom Lydon,editor of ETF Trends, an industry newsletter. To date, he says, socially responsible ETFs are for the most part too new to have a clear track record.
Financial advisers agree that low costs make ETFs important to consider for just about any socially screened portfolio. But knowing when and how to use them, experts say, requires a nuanced approach.
Pros, cons of ETFs in short term
Consider the case of the short-term investor. Funds earmarked for just a few days, weeks, or months in the stock market would potentially be well suited to an ETF because, unlike many mutual funds, they don't charge a redemption fee as a penalty for short-term trading, according to Nathan Foley-Mendelssohn. He's a securities analyst for Boston Common Asset Management, a Boston money-management firm with a focus on social responsibility.
"For investors who, for reasons related to liquidity, need short-term exposure to particular asset classes, ETFs are very useful and have inherent advantages over mutual funds," Mr. Foley-Mendelssohn says. He notes that mutual funds trade only at their end-of-day price, which can make quick, profitable moves difficult to achieve.
But short-term investors who aren't constantly monitoring market gyrations may want to avoid ETFs, says Doug Wheat, a Northampton, Mass. financial planner with a specialty in socially responsible investing.
Mr. Wheat's reason: volatility. Because ETFs trade throughout the day, their values can quickly plunge, he says, especially when holdings are concentrated in a single industry or market sector. That may be fine for long-term investors who will hang in long enough to see prices recover, but those who can't wait may not care for such a ride.
"To the degree that ETFs are investing in companies that are small and where there's a lot of trading going on, it can make them very volatile," Wheat says.
Not everyone, however, worries about rapid market fluctuations for socially responsible ETFs. Values tend to move a lot in a single day or week when speculators are moving quickly in and out of an ETF, according to Angela Thomson, a financial planner in Lincoln, R.I. But, she says, those types of investors are busy elsewhere.
"You don't have hedge fund people going in and out of socially conscious funds," Ms. Thomson says. "It's not a glittery, sort of, 'Oh, I'm going to make a quick buck if I get into this socially conscious ETF.' It doesn't attract the wild riders."
Diversification for small investors
Volatile or not, ETFs serve a variety of purposes for ethically minded investors. Ron Freund, a money manager in Berkeley, Calif., has recommended ETFs to O'Hare, his client, in order to reduce the risks involved in his individual stock-picking habit. But for other clients, he says, that same type of ETF has served desirably to increase prospects for higher rewards (while also increasing risks) by boosting their exposure to alternative energy.
An ETF "allows us to have a diversified position in alternative energy without having to place our bets on specific companies in various industries," Mr. Freund says. "It's particularly useful in our smaller portfolios – let's say, under $500,000 – where we can't necessarily buy locked shares of 10 or 20 different alternative-energy companies without using up so much of the portfolio that it changes the risk profile entirely."
At least six ETFs aim to profit from alternative energy, which Freund identifies as the sector his clients request more often than any other. Among the largest is the PowerShares Wilder Hill Clean Energy Fund, which has a market capitalization of more than $1 billion and claims a 12 percent return over the past year. Others are less than one year old, but they're attracting investment dollars despite their limited track records by specializing, for instance, in industries that cut down pollution from fossil fuels or develop renewable-energy sources.
Ethical investors with an interest in diverse funds have at times profited by getting into ETFs. Example: Barclay's iShares KLD Select Social Index Fund, which avoids tobacco stocks, is reporting a 19.8 percent return over the past year.
But Foley-Mendelssohn notes that cost-conscious investors can save money by going with indexed mutual funds, such as Vanguard's FTSE Social Index Fund, which tracks an index and doesn't rely on active management. Vanguard's product charges a 0.25 percent expense ratio, versus a 0.5 percent expense ratio for the iShares KLD Select Social Index Fund.
Potential tax benefits
Other considerations make ETFs worth a look in certain cases. Investors who need to keep their tax bills down in a certain year, for instance, may find that ETFs incur fewer capital gains than actively managed mutual funds because internal trades, which can trigger capital-gain expenses for investors, are rare with ETFs.
"The person who administers an ETF would only buy or sell holdings if the index they were tracking changed," says Bobbie Munroe, a financial planner with Fraser Financial in Atlanta. "This means that I have a lot more tax control over what happens for my clients by using ETFs."
On the whole, advisers are using ETFs in a range of ways to help socially conscious investors address unique circumstances and achieve highly specific goals. And investors can expect their options in this domain to keep expanding in coming years, Mr. Lydon says.
"The way ETFs are structured allows them to give more specialized offerings," Lydon says, "especially in areas where average investors have not had the opportunity to invest before, such as commodities, currencies, and precious metals.... They are popular for their transparency, liquidity, and tax efficiency. Because of this, providers are offering more for investors."