Like virtually all equity mutual funds, socially responsible investment (SRI) funds got beaten down in the first quarter. However, according to Morningstar (MORN), in 9 of 13 fund categories, the losses for the SRI portfolios were not as severe as were those for the broader category during the quarter. In particular, midcap growth and value SRI funds delivered significantly better performance than their broader categories. A year earlier, before the credit crisis, the reverse was true—the returns of SRI funds in 10 of the 13 categories lagged those of the broader categories.
SRI funds invest in companies with superior environmental, social, and governance (ESG) practices, in addition to solid balance sheets and low debt. In the last year or so, two big themes have helped stem losses in a turbulent market: renewable energy and traditional energy companies focused on fossil fuels. Funds betting on green energy have had huge gains, while those that have avoided or been underweight in oil and natural gas producers have not done as well.
Steadier Plays in a Windier Climate
Managers of these funds also attribute their performance to their long-term investing philosophy. Todd Ahlsten, who manages the $1.04 billion Parnassus Equity Income Fund (PRBLX) in San Francisco, says his portfolio has outperformed the Standard & Poor's 500-stock index by buying underweight financials and consumer-oriented stocks and by owning health-care and technology names. And in energy, rather than making heavy bets on renewable energy stocks (which make up only 2% of his fund), he focused on traditional energy companies that are more progressive in the technology they use, such as Smith International (SII), which makes water-based drilling fluids that are less toxic and more easily recovered from the ground.
It's not enough to focus solely on sustainable earnings growth, he says. "You've got to get the overweights and underweights right at the industry level," he says.
A year ago, when investors were seeking higher yielding assets with little heed to the greater risks they carried, companies with steadier earnings and dividend-paying records weren't being rewarded, says Richard England, lead manager for the $1.3 billion Calvert Social Investment Equity Fund (CSIEX), which is subadvised by Atlanta Capital Management. "That was a little bit of a headwind for us stylistically, and we believe that has changed with the uncertainty of the last year," says England. He expects his focus on more consistent growth and avoidance of cyclicals to turn into a tailwind for the next year or two. By not owning as many companies that can get jerked around by short-term shifts in sentiment, the Calvert fund lost 8.5%, compared with a 9.45% loss for the S&P 500 in the first quarter.
Beating the Market
At the same time, funds that adhered to an aggressive growth philosophy got punished. The Winslow Green Growth Fund (WGGFX) was the worst performing of the three SRI small-cap funds, losing 26.64% during the March quarter, compared with a negative return of 14.51% for the small-cap growth category as a whole, according to Morningstar. Ethan Berkwits, director of marketing at Winslow Management in Boston, blames the fund's aggressive growth strategy rather than its commitment to environmentally friendly investing principles. He admits that part of that growth strategy was being overweight in clean energy stocks, which fell sharply in the first quarter.
Berkwits says he is pleasantly surprised that he has received very few panic-stricken calls from investors concerned about their funds' performance during the depths of the market downturn. "That tells us that, compared to a couple years ago, when we had a lot of outflows after a difficult quarter, this time we've had a real shift in our shareholder base to folks with a longer-term commitment to the green investment perspective we have," he says. That translates to hardly any redemptions, he adds.
At Boston-based Reynders, McVeigh Capital Management, $240 million in separately managed accounts had an aggregate return of just under 1% year-to-date as of May 7, compared with a 2.6% loss in the S&P 500 over the same period. Chat Reynders, a principal at the firm, attributes the performance to "very solid balance sheets and not a lot of leverage in the companies in our portfolios." For the year ended Mar. 31, the accounts that he and his partner, Patrick McVeigh, manage were up over 15%, vs. a decline of just over 5% in the overall market.
Considering that many SRI portfolios traditionally favor financial companies because they tend to fit socially responsible criteria, it's surprising that many SRI portfolios have outperformed other funds. Long before the market woke up to the dangers of the subprime wave, Reynders and McVeigh began to turn away from financials based on a broader understanding of what constitutes a sustainable business. For example, when Business Ethics magazine voted Fannie Mae (FNM) the most socially responsible company of the year in 2004, McVeigh sent a letter to the editor, attacking the government-sponsored enterprise for having turned itself into a large hedge fund by taking on an unwieldy amount of debt as it expanded into new markets. "Business Ethics said Fannie was in the business of building dreams. We said they're in the business of building nightmares by putting people in homes they can't afford," he says.
SRI managers said they don't think the market downturn has caused investors to waver in their commitment to socially responsible investing. Geeta Aiyer, a portfolio manager at Boston Common Asset Management, says a bigger test of SRI investors' commitment has been the past five years, during which the energy-extractive and defense industries have been among the strongest performing sectors. "For years we've been addressing the opportunity costs—what you give up by being a social investor," she says. "Now we see there's opportunity from being a social investor."
In fact, some SRI managers are seeing net inflows of cash into their funds since the year began. All eight of Pax World's sustainable investment funds are showing net inflows year-to-date, including five funds launched within the past nine months, says Joe Keefe, chief executive of the Portsmouth (N.H.)-based investment firm. "That surprises us because I've read that many fund companies are at net outflows because of the markets," he says. "It speaks to the fact that sustainable investing—green investing, call it what you want—is a very hot space right now."
The Many Draws of SRI Funds
The Pax World Balanced Fund (PAXWX) has attracted more than $42 million in cash so far this year. Over $9 million has flowed into Pax World's high-yield bond fund (PAXHX), while the recently acquired Women's Equity Fund (PXWEX) has grown by just over $5 million, says Keefe.
Heightened fears about the economy and corporate profits and valuations may even be helping to attract some investors to SRI funds. One of the draws is active ownership, where shareholders can use their stakes and voting power to force changes in companies' ESG practices. "A lot more clients in times like these, when they have concerns, want to feel a little closer to their investments. They want to know more [about] what's going on with the management of their companies," says Reynders.
Chris Brown, Pax World's chief investment strategist, sees a lot of money coming in from deferred compensation plans from various states. "Municipal employees are demanding to have some kind of SRI/ESG fund in their menu," he says. "All the governance problems that have come up and all the environmental issues have driven tremendous demand for our products."
What's more, Keefe at Pax World thinks investing in socially responsible companies is a smarter long-term strategy because companies that meet higher ESG standards tend to be better positioned for long-term performance and carry lower risk.