During the market rout of 2008, the performance of socially responsible funds ranged all over the map. For example, Vanguard FTSE Social Index (VFTSX) lost 42.4 percent for the year, lagging the S&P 500 index by 5.4 percentage points. At the same time, Amana Trust Income, an Islamic fund, (AMANX) beat the popular benchmark by 13.5 percentage points.
That's easily explained, of course: The social screens used by the funds were responsible for some of the performance gaps. In short, the screens themselves put a bias on the kinds of sectors available to the fund managers. For example, Vanguard, in seeking companies that treat workers “well” and don't pollute, was drawn to financial stocks — 29.8 percent of its assets were invested in financial stocks last year (whoops!). Meanwhile, Amana had no assets in financials because Islamic law forbids investing in companies that charge interest.
Such sector overweightings are common among social funds. “You can build diversified portfolios using social funds, but you need to be aware of the sector biases,” says Chris Cogswell, a financial advisor with Chancery Financial Advisors in Louisville, Kentucky.
Socially responsible funds use a variety of screens that favor certain sectors. Faith-based funds — including portfolios aimed at Protestants, Catholics and Muslims — often shun big media companies because their films are considered immoral. Some Catholic funds refuse to own companies that give benefits to same-sex partners or make donations to Planned Parenthood and other groups that support abortion. As a result, some faith-based funds tend to underweight technology and healthcare companies, which may have liberal policies on homosexuality and abortion. But other traditional sin stocks may be just fine with them. (Funny aside: One investment adviser who manages money for a Catholic institution says that while the institution avoided technology companies that make components for weapons, booze and tobacco stocks were okay.)
Many secular social funds take a different approach, seeking companies that treat workers “fairly” and have strong environmental records. These funds often emphasize technology companies — which cause little pollution — and skimp on energy and manufacturing. That leaves the funds with overweightings in growth stocks.
Advisors seeking to build diversified portfolios must keep a close eye on the sector biases of their funds. If a portfolio becomes overweight with growth names, then it may be necessary to add a value fund, such as Amana Trust Income. Another approach is to pick a diversified social choice, such as Intregity Growth and Income (IGIAX), which deliberately holds a mix of growth and value.
Sector biases can also be a problem for green funds, which focus on companies with solid environmental records. Many green portfolios have a growth tilt because they underweight energy and industrial stocks. A top green choice is New Alternatives (NALFX). Focusing on energy-efficient power production, the fund has half its assets in utilities and no holdings in health care. Portfolio managers Maurice and David Schoenwald favor companies with strong balance sheets and steady earnings, including many dividend payers. To find industry leaders, they often look abroad. A favorite holding is Acciona S.A., a Spanish utility that operates wind farms in the U.S. and Europe. “I like companies that have geographic diversity,” says David Schoenwald. “That way the business can do well even if one or two markets slip.”
Portfolio 21 (PORTX) is a 10-year-old fund that prefers high-quality companies with track records for good earnings growth. The fund buys few energy stocks, and because many alternative-energy companies are young, they don't qualify for the portfolio. Instead the fund managers overweight technology and health.
Portfolio 21 typically has 70 percent of its assets abroad. “When we applied our selection criteria, we found that there were not enough companies in the U.S. that qualified,” says fund co-founder Carsten Henningsen. Many holdings are blue chips, including Finnish cellular giant Nokia and Carrefour, the French retailer.
Islamic screens have presented a special challenge for Amana Income. As an equity income specialist, the fund favors blue-chip dividend payers. Among the biggest dividend payers have been financial companies — but those are strictly forbidden by Islamic law. To find stocks with low price-earnings ratios and steady earnings growth, portfolio manager Nick Kaiser has turned to big stakes in energy and health care. Current holdings include ExxonMobil and Pfizer.
While avoiding financials helped in 2008, the sector bias presented problems in earlier years. “Thoughout the 1990s, financial stocks outperformed, and we were not able to participate,” says Kaiser.
In recent years, the fund overcame its handicaps by emphasizing commodity and materials firms. Those helped Amana stay in the top quarter of its category during 2005 and 2006, years when financials outperformed the S&P 500.
A fund that typically overweights technology and health is Pax World Balanced (PAXWX), which seeks companies that are good corporate citizens with strong environmental records. Portfolio Manager Chris Brown favors consistent growers that sell at reasonable prices (blue chips, such as Procter & Gamble and PepsiCo). “We want businesses that are going to continue to succeed,” Brown says. “Even if the recession gets worse, people are going to drink Pepsi and buy deodorant.”
Because of the uncertainties surrounding health care reform, Brown is avoiding most big pharmaceutical companies. Instead he is holding Becton, Dickinson, which sells healthcare supplies, such as needles. Demand for those should remain steady no matter what rules finally emerge from Washington.
Catholic investors should consider LKCM Aquinas Value (AQEIX). Concerned about abortion and pornography, the fund is underweight media and computer hardware stocks. LKCM Aquinas also steers away from some pharmaceutical companies because of their involvement with stem cell research and contraceptives.
Portfolio manager Paul Greenwell seeks companies that sell at below-average price-earnings ratios, but he only wants companies with steady earnings and healthy balance sheets. “We would not buy most auto companies and airlines, because they have too much debt,” says Greenwell.
A favorite holding is investment bank Lazard. Greenwell says that the company has enough capital to survive the recession and prosper when markets return to normal conditions.