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Good Morals, Good Returns

By Palash R. Ghosh Socially responsible investing (SRI) is rising in popularity as investors seek to match portfolio assets with personal beliefs and values. One of the largest and most successful SRI funds, the $900 million New Covenant Growth Fund (NCGFX), invests according to the principles of the Presbyterian Church (U.S.A.) Foundation. The portfolio automatically excludes companies with significant operations related to alcohol, tobacco, gambling, and firearms.

Good morals have been translating into good returns. For the one-year period through the end of August, the fund gained 17.1%, vs. a gain of 12.6% for the S&P 500, its benchmark, and 12.9% for the average large-cap blend fund. For the three-year period, New Covenant registered an average annualized return of 12.5%, edging out a 12% gain for the index and a 10.6% rise for its large-cap blend fund peers. Over five years the fund dropped 2%, while the index slid 2.7% and its peers fell 2.5%. (Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund a rank of 4 Stars.)

"We are the only SRI fund directly sponsored by a church," says Robert Leech, chief executive officer of the Presbyterian Foundation and president of New Covenant Funds. Based in Jeffersonville, Ind., New Covenant supervises five independent subadvisers -- Wellington Management, Mazama Capital Management, Santa Barbara Asset Management, Sound Shore Management, and Capital Guardian Trust -- that select securities. The subadvisers each focus on a particular asset class or investment style, which helps to diversify the portfolio while controlling risk.

FINAL SAY. New Covenant, a subsidiary of the Presbyterian Foundation, annually draws up a "divestment list" of companies that violate the church's criteria for social responsibility. This list is handed to the five subadvisers, and the companies on it are banned from the portfolio. Afterwards, each subadviser is free to invest in any other stocks that agree with its respective investment-style mandate. The subadvisers operate autonomously and have final say in buy and sell decisions, subject to the screen of prohibited companies.

The subadvisers are allocated a portion of the fund's assets. The bulk of the assets, 61%, are made up of style-neutral, multi-cap core investments run by Wellington. Three "satellite" allocations, each consisting of 13% of the fund's total assets, are managed as follows: mid- and large-cap value stocks (Sound Shore), growth stocks (9% allocated to large-cap specialist Santa Barbara and 4% to small- and mid-cap specialist Mazama), and international stocks (Capital Guardian). Based on this breakdown, the fund is diversified by market-cap size -- 66% in large-cap stocks (above $10 billion), 30% in mid-cap (between $1 billion and $10 billion), and 4% in small-cap (under $1 billion).

"These target allocations may change periodically, but not dramatically," notes George Rue, senior vice-president for investments at New Covenant Trust. "When a certain investment style is hot, we could let the manager go slightly above their target allocation for a while before we rebalance the fund again to its initial level. In the past, the style-neutral core has represented as much as 65% to 66% of the fund's assets. But the basic structure has not changed too much." The fund recently increased its foreign stock allocation, instructing subadviser Capital Guardian to begin investing in emerging markets.

AMONG THE BANNED. Each subadviser was selected for performance, style bias, and investment process. Capital Guardian has been with fund since inception. Wellington and Sound Shore came in 2000, just after the fund's launch. Mazama and Santa Barbara were hired in early 2005 to replace Seneca Capital Management, largely because of poor performance and personnel changes.

The divestment list for the most recent fiscal year included 71 companies -- both domestic and foreign -- most of which were connected to either tobacco, alcohol, or gambling. Banned companies include Boeing (BA), General Dynamics (GD), Altria Group (MO), Anheuser-Busch (BUD), and Harrah's Entertainment (HET). While New Covenant generally bars most stocks of defense and weapons-related companies from the fund, exceptions are sometimes made for those that don't manufacture land mines or nuclear weapons, which kill innocent civilians.

"The primary concern of the church is the overall size of defense spending, foreign military sales, overdependence on military contracts by a company, and weapons that do not distinguish between combatants and noncombatants," Leech says. "Our list of prohibited defense stocks includes a combination of the top five military contractors, the top military contractors whose business is dependent on military contracts, the top five in foreign military sales, and those military contractors whose weapons don't discriminate between soldiers and civilians (nuclear, chemical, biological, land mines)." Outside of this military divestment list, "our subadvisers are free to purchase any other defense-related companies," he says.

LOTS OF HOLDINGS. As of June 30, the fund's top 10 holdings were Citigroup (C), 1.8%; Exxon Mobil (XOM), 1.6%; Microsoft (MSFT), 1.6%; General Electric (GE), 1.5%; Bank of America (BAC), 1.5%; Time Warner (TWX), 1.4%; Intel (INTC), 1.4%; Procter & Gamble (PG), 1.2%; Pfizer (PFE), 1.2%; and CIGNA (CI), 1.1%.

As of that date, the fund's top sectors were financials (19.9%), information technology (17.7%), health care (17.3%), consumer discretionary (13.7%), and industrials (10.7%). The portfolio currently has 783 holdings. The large number is attributed to Wellington's portion of the fund, since its multi-cap core position is benchmarked against the Russell 3000 index. "This 'enhanced' kind of index investing requires a large number of holdings," Rue notes.

The fund's annual turnover typically falls between 60% and 70%. The majority of sell transactions are based on investment fundamentals rather than screen violations. Merger activity can also affect turnover. For example, Vishay Intertechnology (VSH), a diversified electronics company that's banned by the fund because of its military contracts, acquired one of the fund's holdings. That stock was quickly unloaded.

Beyond the investing restrictions, New Covenant monitors its holdings for compliance on social and political issues, including racial equality, environmental protection, labor relations, animal testing, pay disparity, and predatory lending, among others. Through proxy voting and shareholder advocacy, New Covenant may even seek to change a company's policies.

Ghosh is a reporter for Standard & Poor's Fund Advisor

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