Thursday, January 31, 2008

Socially Responsible Investment: Can it beat traditional mutual funds?

Wouldn't it be great to make money and do good for the world? What if you could make more money by investing in socially responsible causes? I think without a doubt every person in the world would love the ability to make more money and feel good about it.

I recently read The SRI Advantage: Why Socially Responsible Investing Has Outperformed Financially by Peter Camejo which investigates evidence which claims to show the benefits from socially responsible investing.

The SRI Advantage - Mini Book Review
The hypothesis that Peter Camejo presents is that socially responsible mutual funds perform better than other mutual funds that have similar risk profiles and size (small/mid/large capitalization). The book challenges the notion that Socially Responsible Investment may "feel good" but only by sacrificing performance.

The fundamental idea is that if a person were to invest in socially responsible stocks then the performance is better. The screening is what any other active fund manager would be doing, but looking at social and environmental aspects to determine a "bad stock". The idea is by only investing in socially responsible companies, it will minimize risk. The case study that they often cite is the tobacco industry. In this case, the lawsuits related to health issues hurt their stock. Thus, if a fund were to screen out companies like this, it would have a better profile that is less susceptible to future losses.

Each fund has its own criteria for determining whether or not a company should be screened out. Some of these screens include the following:

  • Tobacco use
  • Alcohol
  • Military defense
  • Gambling
  • Animal testing
  • Environment
  • Human rights
  • Labor relationships
  • Community Investment
The book cites many studies that have been performed, and many show a correlation between socially screened funds outperforming other comparable mutual funds. There is not a strong consensus that the performance is greater because many index funds for socially responsible funds and indices have only been created within the last 20 years. Their performance has not been completely proven to outperform non-screened funds.

One aspect that the book did not address are the fees associated with the mutual funds. This topic is discussed in the next section and will explain their importance.

Why are expense ratios and mutual fund fees so important?
The old adage goes something like "nothing comes for free". The same is true is for mutual funds and there are costs associated. However, some funds come at a lower price than others. Before I start talking about specific mutual funds, I need to define a few key terms.
  • Expense Ratio: Cost to pay the fund manager and other operation expenses related to running the fund. This percentage is the amount of money you pay from your total principal EACH YEAR to support the fund. Typical expense ratios are over 1% and can reach even 2%. This means that each year you have to pay up to 2% of your portfolio each year to support the manager.
  • Sales Fee: The fee you have to pay the fund to purchase the mutual fund (% of initial investent). Typically between 0-5%. If the sales fee was 5% and you invested $10,000, only $500 would go to pay the fee and only $9500 of your money would be invested in the fund.
  • Redemption Fee: The fee you have to pay the fund to sell your fee (% of the redemption/sale price). Typically 0-2%. If the sales fee was 2% and you cashed out your fund for $10,000, you would have to pay $200 and would net $9800.
As you can see, these fees are not trivial by any means. If you are buying and selling "loaded" funds frequently (those which have sales or redemption fees), the fees can add up very quickly. Picking a mutual fund based on the fees can be as important, if not more important than having a socially-screened fund or past performance.

Social Index Funds:
To find out information about socially screened I looked at the Social Investment Forum for general information about the funds and Morningstar and the prospectuses for the various funds for information regarding the fees and expense ratios.

There were many different funds with varying expense ratios and fees. One fund that stood out was the Calvert Alternative Energy fund which had a sales fee of 4.75% and an expense ratio of 1.85! I chose a few SRI funds to represent some of the more economic choices, but as you will see that even these funds still cannot compare to the low costs of owning a Vanguard fund or similar no load, low expense ratio fund. Although the fees for the SRI funds are similar to typical actively managed mutual funds on the market, they cannot compete with very low expense ratios of Vanguard funds.

Using the SEC Mutual Fund Cost Calculator, I compared some socially screened index funds and compared them to two Vanguard funds which have are "no load" and have much lower expense ratios compared to the SRI funds. Here are the assumptions I made for the calculations.
  • $10,000 initial investment
  • 8% annual rate of return (constant for all funds)
  • Investment is sold after 10 years
  • Fees as displayed in the table below
  • The redemption fees that are listed for funds are not applicable because the funds are held for over 30 days.
  • These stocks are not necessarily in the same class of funds but were chosen to illustrate the effect of fees and operating costs of a fund.

Calvert Social Index A Calvert Social Index C Domini Social Equity Fund Vanguard Total Stock Market Index Vanguard U.S. Growth Fund Investor
Sales Fee 4.75% 0.00% 0.00% 0.00% 0.00%
Expense Ratio 0.75% 1.75% 1.15% 0.15% 0.50%

Assuming a 8% constant rate of return on investment and an initial investment of $10,000, here are the results for investing some different funds. The "Final Value" represents how much the investment of $10,000 is worth in 10 years after paying the operating costs and fees. The "Effective Rate of Return" is the average annual rate of return over 10 years after the fees have been factored in.

Calvert Social Index A Calvert Social Index C Domini Social Equity Fund Vanguard Total Stock Market Index Vanguard U.S. Growth Fund Investor
Final Value $18,873 $17,723 $18,846 $21,268 $20,534
Effect Rate of Return 6.56% 6.10% 6.76% 7.84% 7.46%

Clearly, investing in a no load, low expense ratio fund has clear advantages when compared to one a "better-performing" socially responsible investment. I calculated what type of interest rates the Calvert Social Index A would need to be if it were held for 10 years to compete with the Vanguard Total Stock Market Index. The Calvert Social Index A Fund would need to have a rate of return of 9.2% (before fees and taxes) to compete with a fund that got 8% in the Vanguard Total Stock Market Index.

My Thoughts
Although I think it is a great idea to support "socially responsible" companies, however you may define "socially responsible", I think that the data is not conclusive yet to see if socially responsible investing is worth it in pure economic terms. They have cited some studies which have shown that SRI funds have outperformed non-socially screened funds. However, many of these studies are based on index funds that are very young.

Upon examination of the website "Social Investment Forums", it is clear that the majority of these funds DO NOT outperform their respective comparison indexes just like the majority (90%) of actively manged mutual funds. Until there is stronger evidence that socially responsible investing is more effective than traditional investment, I personally would not invest in them from an economic perspective.

Even if one assumes that they can perform as well or even better than a non-screened fund, there are still the fees, including the annual operating cost (expense ratio), the sales fee, and the redemption fees which all must be calculated into it. Unfortunately, because these funds are screened, it means that they are actively managed which invariably leads to higher fees, in particular the expensive ratio.

In short, why would you want to give your hard earned money to fund managers who cannot outperform the index or even other funds in a similar class. The advice I'm going to give isn't anything revolutionary, but I will say it again because many investors think they can beat the market by giving their money to a fund manager.

Invest your money in a no load, low expense ratio fund like those offered by Vanguard. Only invest in an socially responsible fund IF AND ONLY IF you can find one a no load, low expense ratio fund. Otherwise your too much of your money will be going to the fund manager. Even then, be sure to diversify your investment so that you don't have all of your eggs in one basket.

Disclaimer: This blog should not be considered professional financial advice. Please consult your CPA for more information about investing decisions.

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Ron Robins said...

Great to see you liked Peter Camejo's book!

One other source for socially responsible investing information is my site which uniquely covers all the latest relevant global news and information on the subject. (I've also been following SRI for over forty years.)

You can find my site at

Good luck and best wishes to you and all your readers. Ron Robins

Huefunder said...

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