Monday, December 19, 2005

Investing in Sin

In the battle of good and evil, evil is winning—at least in the investment world.

Socially Acceptable Mutual Funds

Scanning through my portfolio last weekend, I noticed that I own shares in a number of companies that profit off the seeming misfortune of others: an online gambling company, two pharmaceutical companies, a slot-machine manufacturer, and the most hated software monopolist in the world (my first investment ever—I know, real original…).

Profiting at the expense of another made me ponder the nature of the so-called Ethical or Socially Responsible Investing (SRI).

"Ethical Investing" depends on your personal definition of "ethical." Generally, Socially Responsible mutual funds shun fairly obvious industries such as tobacco, alcohol, or gambling. Others introduce criteria by investing only in companies that are friendly to the environment, treat their employees fairly, promote diversity or pass other social screens. There are even funds designed for Catholics, conservative Christians, Mennonites, Muslims, Presbyterians and others.

These funds have exploded in popularity the last few years and have performed quite well. A quick look at illustrates the wide variety of available SRI funds that promise socially responsible investing techniques.

Are Socially Responsible Funds good investments?

First, let me introduce you to the Vice Fund (aka the Socially Irresponsible Mutual Fund). Created in 1994 by Dan Ahrens, The Vice Fund invests exclusively in those “sinful” stocks which the SRI funds purposely avoid! For those who love drinking, smoking, gambling & war-mongering, this is the fund for you!

Top 10 Fund Holdings as of 10/31/05:
4.9% - Altria Group
4.4% - British American Tobacco
3.8% - Diageo PLC
3.7% - Constellation Brands
3.6% - International Game Technology
3.5% - L-3 Communications Holdings
3.5% - Imperial Tobacco Group
3.4% - Anheuser-Busch Companies
3.0% - United Technologies Corp.
2.6% - General Dynamics Corp.

And the Vice Fund has been performing quite well—much better than the majority of Socially Responsible funds, in fact! But are these results surprising? Not in a capitalistic society that rewards unethical business practices, allows political ties, and showers citizens with mass marketing campaigns promoting “sinful” products. And the results don’t lie:

3 Year Lipper Quintile Ranking: 1
Annual Return: 19%
Lipper Percentile Ranking: Top 9%
Multi-Cap Core Category Rank: 48th out of 570 funds

So maybe investing in sin is just good investment practice (if you can sleep at night)! The Vice Fund Prospectus explains, “Although often considered politically incorrect, these and similar industries and products...will continue to experience significant capital appreciation during good and bad markets. The Advisor considers these industries to be nearly ‘recession-proof.’”

Furthermore, most Socially Responsible funds charge outlandish fees as compared to other mutual funds (perhaps they need to extend their definition of ethical). The Sierra Club Stock Fund, for example, takes back 1.84% of your assets each year to pay its expenses. That starts the Sierra Club fund off at a disadvantage to its market peers and partly explains why it has lagged the S&P500 by more than five percentage points since its inception in 2003.

Socially-Responsible Funds are just a Marketing Ploy

Are these self-described Socially-Responsible funds really more virtuous? Again, it depends on your definition of ethical. The Sierra Club fund does not hold any energy or utility companies, although it does count Amgen (NSDQ:AMGN), a pharmaceutical company that performs tests on animals, and casino operator MGM Mirage (NYSE:MGM) among its top holdings.

Forbes magazine recently ran a "Social Scorecard," which graded many of America's most admired corporations on diversity, community, human rights, and the environment. The grades ranged from A to F, and none of the 30 firms avoided earning at least one C, D, or F grade. In fact, only Johnson & Johnson (NYSE:JNJ) and Intel (NSDQ:INTC) managed to earn three A's and/or B's.

I'm not enamored by so-called ethical investing, because I think that most times it's more marketing-driven than value-driven. That's not to say that all socially responsible funds are the same. Indeed, if you want to dig deeper, the Vanguard index (with its low expense ratio) is a good place to start. But buyer beware: check every socially responsible fund's holdings before you invest. You'll want to make sure that you see eye to eye with the manager.


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