When money manager Lloyd Kurtz listens to clients these days, he hears a message that's gaining currency across the world of ethical investing.
"The most common question I get from clients is, 'How can we make this portfolio more socially positive?' " says Mr. Kurtz, a senior portfolio manager at Nelson Capital Management in Palo Alto, Calif. "Just avoiding bad companies doesn't cut it anymore."
One solution has been positive screening - a strategy that sets the social or environmental bar high enough so that only top-performing firms win an investor's dollars. The approach breaks from the status quo of socially responsible investing (SRI), a movement now in its fourth decade. To date, SRI mutual funds have emphasized a two-pronged approach: negative screens, which avoid certain companies, such as those connected to tobacco or weapons manufacturing; and shareholder activism, which pushes for policy changes inside companies that have questionable practices.
According to certain measures, such conventional SRI methods have been struggling. Having largely avoided market-leading petroleum and defense industries, the benchmark Domini 400 Social Index trails the Standard & Poor's 500 in returns over one-, three-, and five-year periods.
So some ethically minded investors are seeking a new way to link investments with personal values by exploring what positive screening has to offer. A few new mutual funds in the United States and Canada have popped up to satisfy that demand.
But investors should use caution before they plunge into positive-screened funds, says Christopher Geczy, an assistant professor of finance at the University of Pennsylvania's Wharton Business School. In an updated study of mutual-fund performance over the past 40 years, he found that investors who put limitations, including positive screens, on the funds they considered tended to receive lower annual returns. In fact, their returns were three to four percentage points less than their counterparts who put no restrictions on their portfolios. The reason: inadequate diversity to buoy lackluster performers in down markets.
But some money managers are hopeful that positive screening will yield more profitable harvests. Risks have diminished over the past five years, they say, because more public companies measure up to ethical standards.
One fund generating some excellent results lately is the Winslow Green Growth Fund. Portfolio manager Matthew Patsky hunts for small "environmentally proactive" companies, meaning those whose primary products somehow enhance the environment, such as solar energy or natural foods.
To strike a balance across industries, Mr. Patsky chooses some firms that are either environmentally "responsible" (e.g., a paperless travel agency) or "benign" (e.g., software). Unlike many SRI funds, Winslow Green Growth avoids "best in class" performers from what Patsky terms "dirty" industries, such as petroleum. And the fund doesn't agitate for social change inside the firms it owns.
Results tell Patsky he's onto a winning, albeit sometimes volatile, formula. Up 31.6 percent over the past year, the fund's average returns over the past three, five, and 10 years have been 35.3, -2.5 and 20.0 percent, respectively. Still, the dangers of trusting primarily in "proactive" firms delivered a painful lesson in 2002 and 2003 when renewable-energy stocks tumbled.
"It was a major bet that was wrong," Patsky says. "What we were betting was a rational outcome to an analysis of what happened on 9/11," but investors didn't flock to oil alternatives as he'd expected. As a consequence of that experience, proactive stocks now make up just 25 percent of the portfolio, as opposed to the 50 percent they represented in 2002.
As the Winslow fund backs off somewhat from its "pure plays," however, other funds are organizing to exploit some pure plays of their own. In January 2005, Barclays Global Investors launched the iShares KLD Select Social Index Fund, the first socially responsible exchange traded fund (ETF). Its stated purpose: "optimizing positive social and environmental criteria while seeking to reduce sector risk."
In August, Parnassus Investments unveiled the Parnassus Workplace Fund on the principle that "companies whose employees love going to work will do better than companies with poor workplaces." The fund aims to profit by bulking up on firms with "equitable pay, family-friendly benefits, training and educational opportunities," among other factors.
Not all positive screeners, however, have had much to celebrate in recent years. Since its inception in September 2003, Real Assets' Social Leaders Fund has showcased solely social and environmental pacesetters such as Timberland and United Natural Foods, but returns have measured a paltry 2.8 percent per annum. Another positive screener with an eye on clean energy sources, the New Alternatives Fund, still hasn't climbed back to its January 2001 trading price of $38 per share.
But proponents of positive screening insist that just because one screening criterion isn't paying dividends at the moment doesn't mean all positive screening is hopeless.
To the contrary, positive screening can work for anyone from a left-leaning hippie to a social conservative, says Marc J. Lane, an attorney and financial planner in Chicago. The key, he says, is to establish one specific positive screen, such as good labor relations or environmental sustainability, but not both. Then be flexible in other areas.
"Where we do run into trouble is with a client who claims to be equally committed to environmental issues and social justice issues," says Mr. Lane, who defends the positive screening strategy in his 2005 book, "Profitable Socially Responsible Investing?" "To do all that, you end up with a best-in-class approach" that selects companies with marginally acceptable records in both categories rather than exemplary marks in either one.
By making trade-offs, Lane says, a portfolio can reflect an investor's highest social value while also reaping the stabilizing benefits of diversification. The best way to set a screening criterion, he says, is to discover an investor's deepest passion and put it to work.
Others argue that positive screening works best when the criterion necessarily points to firms with a marketplace advantage. Example: Portfolio 21, a mutual fund in Portland, Ore., searches the globe for companies positioned to thrive in an anticipated era of "environmental crisis."
"By being strict with environmental criteria, perhaps you're making the business case" for the long-term profitability of firms prepared for such major problems as global warming, says Carsten Henningsen, Portfolio 21 cofounder. Having outpaced the Standard & Poor's 500 Index since inception in 1999, the Fund in Mr. Henningsen's view is vindicating its foundational theory.
Though the strategy is far from perfected, even skeptics say there's hope for positive screening. Geczy, for instance, who says investors hurt themselves when they screen out mutual funds according to social criteria, suggests they might do well by using the same screens to pick individual stocks. Here, he suggests, they can learn from their institutional counterparts.
"Institutional investors that do direct investing may in some cases [be] close to optimal portfolio allocations when they overweight according to positive screens," Geczy says. Because so many companies now meet high social standards, he says, "more than ever, you can invoke these constraints and you're not necessarily worse off" in terms of projected financial returns.