Profit Without Purgatory

"You will find that many of the truths we cling to depend greatly on our own point of view."
-- Obi-Wan Kenobi, Return of the Jedi

I was scanning through my portfolio the other day when I noticed that I own shares of a number of companies that profit off the (seeming) misfortune of others: an online gambling software provider, two defaulted debt collection companies, a bankruptcy software provider, and a super-catastrophe insurer. Heck, until earlier this summer, I also owned a death-care provider.

Earning a return at the expense of another made me ponder the nature of so-called ethical or socially responsible investing (SRI), terms that I use interchangeably.

The definition of "is" is ...
At the risk of sounding positively Clinton-ian, "ethical investing" depends on your definition of "ethical." Generally, funds that make the social responsibility claim shun fairly obvious sectors such as tobacco, alcohol, or gambling. Others introduce some fuzzy criteria about not investing in companies that profit from pornography, that don't reflect proper diversity in their workforce, that treat employees unfairly, or that don't pass certain environmental or social screens. All of this sounds good in fund promotional material, but without firm definitions, the concept of social responsibility can become lost in the ether.

For instance, take a look at this wide swath of funds that promise socially responsible investing techniques. While most of these funds refuse to invest in companies like Altria (NYSE: MO  ) , the tobacco giant that has returned 21.5% annually (including dividends) over the past two decades, the standards muddy a bit from there. What would they make of the contribution in-room adult entertainment has on the bottom line of hotelier Four Seasons (NYSE: FS  ) ? How would they classify Boeing (NYSE: BA  ) -- as weapons dealer (bad) or commercial airliner manufacturer (OK, unless you're counting the environmental effect of burning hydrocarbon jet fuel at high altitudes)?

Slipping on the environment
Socially responsible investing falls closest to my heart concerning environmental issues. (I am an environmental engineer by trade, holding a master's degree in the discipline, and I have nearly a decade of industrial practice.) In the interests of being somewhat provocative, if all investors were to adhere to rigid environmental protection criteria as a screening tool, then there are no companies that would be worthy of our investment dollars. The reason: Commerce always affects (read: harms) the environment. Of course, environmental harm is a bit of a slippery slope, and experts rarely agree on what is harmful.

Ethical and economic solutions
Perhaps I'll come off as an unabashed capitalist and proponent of a "let the market decide" line of thinking, but the most environmentally friendly solution may also be the most business-friendly. My former employer was an emitter (a nicer word than "polluter") of a particular carcinogenic degreasing solvent. It was the second-largest polluter ... err emitter ... of this substance in Canada in the late 1990s. As the lead engineer on the project, my team and I developed a new process that completely eliminated the use of the chemical from our facility. Quantifying only the savings from chemical purchases and hazardous waste disposal (and there were also productivity and health and safety gains), the project paid for itself in just about four years.

Were our emissions causing environmental harm? Yes, in my opinion. Yet the government regulation in force at the time allowed for 10 times the emissions we were pumping into the air. But it was in our self-interest to implement the project. You see, pollution indicates an inefficient process. That inefficiency has a cost. Competitive businesses profit by driving down costs and earning greater returns on capital.

Ethics schmethics
It would be optimal if we could all invest ethically. After all, our dollars are one of the best ways to make businesses appreciate our concerns.

Yet most socially responsible mutual funds charge outlandish fees (perhaps they need to extend their definition of ethical). Consider Sierra Club Equity Income, which charges a ridiculous 1.72%. Vanguard Calvert Social Index, by comparison, charges a measly 0.25%. That starts the Sierra Club fund off at a disadvantage to its market peers and partly explains why it has lagged the S&P 500 by more than five percentage points since its inception in 2003. The Sierra Club fund does not hold any energy or utility companies, although it does count Amgen (Nasdaq: AMGN  ) , a pharmaceutical company that performs tests on animals, and casino operator MGM Mirage (NYSE: MGM  ) among its top 25 holdings.

In Canada, I'm struck by how much Ethical Funds' Ethical Growth Fund resembles any other Canadian equity fund: its top five holdings include the Bank of Montreal, Toronto Dominion, and CIBC, plus energy companies Encana and Suncor (NYSE: SU  ) . If I'm casting ethical stones here (and I suppose I am), I'd be asking why noted Enron financier CIBC ranks so highly, and how a fund promoting environmental stewardship has such a high weighting for an oil sands company.

But most galling to me is that this fund has underperformed its index by a cumulative 38% (including the hefty 2.38% management fee) since inception 15 years ago. That's a cost of $17,000 in today's portfolio value, starting with an original $10,000 investment.

The Foolish bottom line
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.

Fool fund guru Shannon Zimmerman has highlighted a Champion SRI fund in his Motley Fool Champion Funds newsletter. That fund has a reasonable expense ratio and an experienced management team with a proven track record -- and it has bested the market by nearly five percentage points to date. To see what it is and to read about Shannon's more than 30 other Championship-caliber funds -- funds, that is, with low fees and talented managers -- click here to take a 30-day free trial.

Perhaps it's cold-hearted, but the purpose of investing is to make as much money as possible. Shunning a particular company's shares arguably has little effect on the ethical stance of that company, because the money paid for shares doesn't land in their coffers anyway, but rather into the pocket of the person you bought them from. It may just be more effective to use your ethical discretionary dollars in your direct purchases of cars, food, or other leisure good and activities. So-called distasteful businesses like online gaming, debt collection, or death care are doing well because there is strong end-user demand. Directly affecting that demand will do more to put your own personal ethics into action than buying or selling a stock.

Jim Gillies does not own shares of any company mentioned in this article. He'll step off the soapbox now, in expectation of some vicious feedback! The Motley Fool has a disclosure policy.


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