Not So Bad at Do-Gooder Funds


By Amy Tsao With all the worries surrounding corporate scandal and volatile markets, investors are scrambling to figure out how to spot unethical companies. They might want to take a cue from socially responsible investing funds (SRIs). After all, stock-pickers' traditional screening methods, such as scanning the financials, reading annual reports, and relying on audits, have proven insufficient.

Morningstar lists some 148 funds under the SRI umbrella. Typically, they steer clear of companies that are polluters, make nuclear weapons, or offer alcohol and tobacco as products. But they also tend to keep a closer eye on board independence, options expensing, executive pay, and independent auditing.

Over the years, these funds have proven that they can hold their own, or sometimes outperform, funds in similar categories. Morningstar says the average SRI fund lost 11.6% so far this year. Not a bad showing considering the S&P 500-stock index is down 23%. But investors should note that overall performance of the SRIs encompasses all the different types of funds, not just stock funds. These SRIs run the gamut from hybrid bond and stock funds to straight stocks bundled from across all of the major sectors.

OOPS ON ENRON. Performance differs from fund to fund. And anyway you look at it, it has been a bad year for stock funds. Virtually all of them have lost money. However, some SRIs have managed to outdo their peers in the same category. For example, Walden Social Balanced Fund (WSBFX) is off 7.9% year-to-date, while the small-blend investing style category overall is down 13.6%. Another SRI fund, Ariel Appreciation Fund (CAAPX), which uses a mid-cap blend strategy, is down just 7.9% so far this year, while the broader mid-cap category is down 15.7%.

Of course, even SRIs make mistakes. Take Enron. Plenty of SRIs held it -- and got burned when it collapsed last year in a massive accounting scandal. That's because it showed none of the possible flaws that SRIs track. Though nerves about the energy trader's growth projections and complicated structure kept some SRIs out of Enron, the blowup was a wake-up call. In response, many say they're now more stringent than ever on how they select stocks.

Still, the investing community could learn a thing or two from SRI funds since they're well-versed in screening for undesirable or problem traits about companies. And that could prove to be a plus in the post-Enron environment. "We've had some advantage in judging concerns about ethical management," says Bill Apfel, director of research at SRI fund company Walden Asset Management, a division of United States Trust Co. in Boston. "If you're an investor who really looks at the whole business and thinks about how management acts, you can get clues on how they treat accounting."

BEYOND THE OBVIOUS. Recent data suggest that investor interest in SRIs is already running high. According to fund research company Lipper, overall, stock funds experienced outflows of $12.7 billion in June (net after new money is invested and redemptions are made). Yet, SRIs had inflow of $47 million during the same month.

Jeff Schappe, chief investment officer of Citizens Funds, says his company's SRIs look beyond the more obvious measures of social responsibility. Those include quality of management, independent boards, financial auditors without conflicting interests, and reasonable management compensation. Scheppe notes that Citizens missed the blowup of subprime lender Providian (PVN), which by Citizens' standards, didn't account for potential bad loans conservatively enough.

Citizens Funds, has, however, done well investing in regional bank East West Bancorp (EWBC), which has been more conservative on accounting and is expected to deliver solid earnings-per-share growth of 23% in 2002.

"LESS WILLING TO FORGIVE." Many other funds say they've become even more vigilant in figuring out ways to avoid the kind of financial wrongdoing discovered at Enron and WorldCom. "Philosophically, we have the same practice [as before], but we have come to look at companies much more carefully," says Apfel. "We're less willing to forgive practices that we overlooked before."

Calvert Group, which sells SRIs, looks at company investigations that have ended with either indictments, pleas, fines, or settlements, and compares those costs with the size of the company, says Julie Gorte, director of social research at Calvert. So the Securities & Exchange Commission's fine of $10 million for accounting fraud at Microstrategy (MSTR) measured up very differently to the same-size fine imposed on Apr. 11 at Xerox (XRX), whose shares Calvert does own.

Why Xerox? Besides being a much larger company that could absorb the fee, it also gets good marks for workplace quality, and it does a respectable job of environmental management, Gorte says. Admittedly, this screen looks at issues after a problem has occurred, but it's meant to "bolster our defenses against companies playing games," Gorte says. Alas, Xerox shares have fallen 42% year-to-date.

TELLTALE SIGNS. Calvert also keeps on its radar screen companies whose accounting has investors nervous, even if they're not under any official investigation or no settlement fees have been incurred. Gorte says Calvert managers are staying away from Halliburton (HAL) and Cendant (CD), and it had been skirting Qwest Communications (Q) even before the telecom's July 28 announcement that it would be restating earnings. These companies, Gorte says, "haven't officially failed on our accounting criteria, but have all failed other criteria" like product quality or treatment of customers.

Calvert is also putting together a screening model for corporate-governance problems, culled from data compiled by Institutional Shareholder Services. The ISS data ranks major companies on 51 separate measures from compensation to provisions like anti-takeover pills and independence of boards. "We have started to implement a guideline that would call for us to avoid altogether those companies whose scores are the lowest," Gorte says.

SRIs also have a not-so-secret weapon to effect change -- high-profile shareholder resolutions during proxy votes. "The most direct way that mutual funds can have influence over corporate governance is through our proxy voting policies," says Adam Kanzer, director of shareholder activism at Domini Social Investments. "We're trying to figure out which are the key corporate-governance policies that will also help improve social and environmental performance," Kanzer adds.

GAINING SUPPORT. In fact, along with labor unions and pension funds, SRIs are among the most active in presenting shareholder resolutions in an attempt to influence company behavior. Take Walden Asset Management's efforts with data storage company EMC (EMC) to make its board more independent. Walden's resolution has support from 56% of votes cast in 2002, vs. an average 22.5% support for this type of proposal last year, according to Investor Responsibility Research Center, a corporate research firm.

Then there's a shareholder resolution proffered by Domini asking consumer-finance company Household International (HI) to hold its top execs responsible for staying away from predatory lending practices. The resolution would tie executive compensation to stopping predatory lending. It has 27% support so far, vs. just an average of 9.5% last year for similar proposals.

No accounting screens or proxy battles will serve as silver bullets, concedes Calvert Group's Gorte. The best way to avoid accounting fraud is still to look at a company's fundamentals and break down the financial statements. "If you want to defraud, it's hard for investors to see it," says Eric McKissack, portfolio manager for the Ariel Appreciation Fund. "There are signs, but even those aren't foolproof. All we can do is as much research as we can."

GOOD CITIZENS. SRI fund managers make the case that socially responsible behavior -- getting companies to use recycled materials, abide by environmental standards, and treat employees fairly -- will always have a strong relationship with the bottom line. Companies that prove themselves good corporate citizens are less likely to engage in rule-bending and are, thus, more likely to prosper over time, the theory goes.

"A company with poor labor relations may do well. But we're betting that it will have management issues," says Citizen's Schappe. "An unhappy work force will be reflected in the fundamentals."

Perhaps. But the bottom line is fund performance. And socially responsible funds have suffered this year along with funds overall. Now comes the intriguing part. SRIs' strategies may have useful lessons for rooting out potential problems and enacting corporate change. And savvy investors might want to watch closely if such funds outperform in the months ahead. Tsao covers the markets for BusinessWeek Online in New York


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