Ethical Investing's Smoking Gun

A new study finds socially responsible funds with stock in Big Tobacco and others with a taste for Big Macs and defense contractors

By Jessi Hempel

Do you know what holdings your socially responsible investment (SRI) fund screens out? Before you make assumptions, better read the fine print in the prospectus. Across the world, nearly 600 publicly available funds representing $127 billion in assets advertise themselves as SRI funds. They claim to screen out companies that harm the environment, grow tobacco, have lousy equal-employment opportunity records, or manufacture weapons, among other things.

Yet an Oct. 15 study by the San Francisco think tank Natural Capital Institute reveals that many of these funds have holdings in companies that have practices that could be considered socially or environmentally questionable. The study's author, environmentalist Paul Hawken, suggests that SRI funds need to adopt a set of common standards and promote transparency.

DRAWING THE LINE.

  Among Hawken's findings: 12 SRI funds held shares in defense contractor Raytheon (RTN ) as of Dec. 30, 2003. A dozen owned shares in cigarette maker Altria Group (MO ) (formerly Philip Morris), while 40 held oil monolith Exxon Mobil (XOM ), and 19 owned Monsanto (MON ), which produces genetically modified seeds. Twenty-three funds held shares in Halliburton (HAL ), while 41 funds had share in McDonald's (MCD ), which Hawken calls unacceptable in the face of the country's growing struggles with obesity. (Some of the funds had multiple holdings that Hawken terms questionable.)

While policies at each of these corporations may raise questions for investors with a social conscience, there are no strict requirements for what screens an SRI fund must use. Consider the popular Domini Social Equity Fund. Hawken criticizes it for its $9.8 million stake in McDonald's. Founder Amy Domini says the investment is justified because McDonald's has promoted diversity from within and made great strides in its environmental practices. Also, investors haven't asked for the fund to screen for obesity. Says Domini: "If they do, we'll certainly respond, but there's no momentum there." The fund's investing policy, according to fund literature, is to screen out companies "with egregious social and environmental records, be an active shareholder in existing holdings, and use investments to rebuild struggling communities."

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  So, where does the socially conscious investor draw the line? And what about a fund that promotes its SRI policy? Is a fast-food company, which potentially contributes to the obesity epidemic, in the same category as a tobacco company? Plus, a mutual-fund manager's subjective determination could please some investors and turn others off.

These grey areas have prompted Hawken to advocate for greater transparency and more standards across the industry. He says funds should be required to give more specific explanations about why they include companies in their portfolios, and the information should be made more easily available to investors. Hawken also supports a rating system that takes economic returns as well as social and environmental matters into account.

The Social Investment Forum (SIF), a trade organization for SRI funds, calls the lack of standards a strength. Says Alisa Gravitz of the SIF: "SRI funds offer a wide range of options for investors in order to meet diverse ethical and investing criteria." She also says that SRI funds often invest in questionable companies as a strategy to create social change by pressuring management for reform through shareholder activism. Hawken refutes this, saying only 10 fund companies proposed proxy initiatives in 2003. He says: "Small Catholic charities proposed more initiatives than SRI funds."

"PORTFOLIO CREEP."

  Ultimately, SRI funds have a tricky objective: they aim to adhere to a bottom line that equally values economic, social, and environmental return. Hawken says the pressure to perform economically leads to what he calls "portfolio creep" -- questionable investments.

Does this mean it's impossible to achieve superior economic returns while simultaneously making the world a better place? We won't know, says Hawken, until SRI funds have a single set of standards by which to guide their investments. In the meantime, investors should look beyond the labeling to find out where their mutual fund's money is going.

Hempel is a staff editor for BusinessWeek in New York

Edited by Patricia O'Connell