Socially Responsible ETFs: The Other Value Investing

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Socially responsible investment (SRI) is about investing in values. Socially responsible ETFs select companies based on political, social, environmental and corporate governance considerations. Can ethics and values be profitable? Or must investors forgo profits for the sake of their belief system?Unethical behavior is not profitable. Accounting fraud, faulty risk management controls, and environmental sloppiness can send firms into bankruptcy. When companies are made responsible for injuries their products cause, shareholders are hurt. An ETF that comprised of companies avoiding these situations would be a winner.But over the long term, some of the best performing investments are in sectors many investors find objectionable. Tobacco, alcoholic beverages, gaming machines, defense contractors, oil exploration and drilling companies are all often stellar performers. Investors in socially responsible ETFs must balance these realities.There is no ultimate agreement about what constitutes socially responsible investment. SRI-focused ETFs take a variety of approaches to the challenge of investing in good without sacrificing financial performance.One approach is to focus on a particular sector and invest in companies that develop alternatives to that sector. If the environment is a priority, for example, ETFs focusing on alternative energy are an option. There are many such funds. PowerShares WilderHill Clean Energy (NYSEArca:PBW - News) is one of the oldest and best established alternative energy ETFs. The 5-year chart below compares the performance of alternative energy fund PBW with the traditional energy providers, represented by the Energy Select Sector SPDR (NYSEArca:XLE - News).

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The chart shows PBW losing out to XLE, particularly in the last year. XLE holds major oil producers like Exxon Mobile and Chevron and oil service companies like Halliburton. Luckily for investors in XLE, there is little exposure to British Petroleum. PBW by contrasts holds companies that aim to be cost-competitive with fossil fuels but often are not yet competitive and therefore are partly or wholly dependent on government subsidy. These companies are much smaller than the major holdings in XLE. They do not have proven cash flows. They tend to be more volatile.Another approach to socially responsible investment is to focus on the market as a whole but choose companies thought to have comparatively superior record of environmental, social and corporate governance relative to their peers in the same sector. iShares KLD Select Social Index (NYSEArca:KLD - News) takes this approach. It holds 200-300 companies chosen from the S&P 900 Index. The sector allocation is almost identical to the SPY benchmark so big energy companies for example are allowed. But KLD holds no tobacco stock and a smaller allocation goes to utilities and energy companies when compared with the benchmark.The chart below compares the 5-year performance of KLD with a mutual fund from USA Mutuals called the Vice Fund (VICEX) that holds "vice" stocks: tobacco, gaming, defense companies, oil. The domestic benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY - News) is also shown.

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The chart shows, first of all, how closely KLD tracks the benchmark SPY. This is a success for KLD. Second, it shows that there is a long period where the vice stocks outperform the benchmark. Are vice stocks simply more profitable? The most important difference occurs between January 2006 and the Summer of 2008. This is partly due to the rise in oil over this period.Because KLD so closely tracks the SPY, the chart below compares just vice stocks with KLD, this time on a 1-year basis.

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Here the chart shows vice stocks again outperforming. Why? As the market tumbled in August 2010, the defensive character of tobacco and alcoholic beverage companies won over investors. These companies have strong cash flow, pay regular and high dividends, and produce products that resist cyclicality, like tobacco.But sometimes vice does not outperform. In strong markets defensive companies like tobacco and beverages tend to underperform. The chart below shows the 2-year performance of the same funds.

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Here the vice lags. From the Summer of 2009 to the Spring of 2010, KLD (and the benchmark) rose 40% and the vice fund only 20%. Again cyclicality is a par culprit. The broad market dropped more severely during the prior sell-off than the cash-rich vice sector.For some investors the market-targeting approach taken by KLD is not ambitious enough. They point to KLD's small position in Halliburton, which was involved in the BP oil spill as well as a major contractor in Iraq as an example of deviating from socially responsible objectives.These investors should take a look at the iShares KLD 400 Social Index (NYSEArca:DSI - News). DSI is at once more selective and more pro-active compared with KLD. It automatically excludes investments the SINdex-- tobacco, alcohol and gambling. It also excludes companies involved in weaponry and nuclear power. DSI overweights companies with strong environmental corporate governance and human rights records. Of course none of these considerations automatically keep Halliburton or Cameron International out of the portfolio-- at least prior to the BP oil spill.Over the last decade alternative energy ETFs have mostly underperformed conventional oil and oil service funds, defense contractors and notorious carbon polluters in the power generation business. But this long-term trend may be under attack. Concern about the environment is heating up. Public disgust with corporate malfeasance is increasingly important. Environmentally friendly technologies are becoming more prominent and profitable. Socially responsible investment, when done properly, can bring strong returns.Following is a list of ETFs with a focus on social responsibility:Responsible CompaniesiShares KLD Select Social Index (NYSEArca:KLD - News) 0.5%iShares KLD 400 Social Index (NYSEArca:DSI - News) 0.5%Alternative EnergyPowerShares Wilderhill Clean Energy Portfolio (NYSEArca:PBW - News) 0.60%PowerShares Wilderhill Progressive Energy Portfolio (NYSEArca:PUW - News) 0.60%First Trust NASDAQ Clean Edge (NasdaqGM:QCLN - News)0.60%PowerShares Cleantech Portfolio (NYSEArca:PZD - News) 0.60%Global Alternative EnergyVan Eck Market Vectors Global Alternative Energy (NYSEArca:GEX - News) 0.65%PowerShares Clean Energy Portfolio (NYSEArca:PBD - News) 0.75%Solar EnergyClaymore Global Solar Energy (NYSEArca:TAN - News) 0.65%Van Eck Market Vectors Solar Energy (NYSEArca:KWT - News) 0.65%Wind EnergyFirst Trust Global Wind Energy Fund (NYSEArca:FAN - News) 0.60%Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.

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