Your Conscience Is a Lousy Investor

Putting your money in socially responsible companies is a moral decision. But it's not an investment strategy.

In sectors where consumer opinion matters, charitable donations boost sales. But while a donation may be a clever move for business, that doesn't necessarily make a company a good investment.

One goal of the nonprofit Maala - Business for Social Responsibility is to convince investors to choose companies that choose to be socially responsible. For this reason, Maala and the Tel Aviv Stock Exchange initiated the Maala Socially Responsible Investing Index, which includes companies from the Tel Aviv-100 Index that Maala has deemed socially responsible.

AP

The Maala-SRI index, launched in February 2005, lists 38 companies. Investors can buy into the index through KSM's exchange-traded note KSM Maala or Psagot's mutual fund Psagot Maala.

Comparing the Maala SRI Index to the TA-100 can tell us whether contributing to society indeed makes a company a better investment. Through 2008, Maala SRI kept close pace with the TA-100, but in 2009 and 2010 it began lagging behind Tel Aviv's main benchmark.

Since its launch, Maala averaged annual returns of 8.6%, while the TA-100 averaged 10.6%. Maala returned 62% over the past six years, while the TA-100 returned 82%.

Israel isn't the only country that has tried to push investors to pick socially responsible companies. Such investment options exist in the United States, too. One is via iShares' exchange-traded fund KLD, which tracks the MSCI USA ESG Select Index. This index includes 190 companies committed to the environment, society and governance, or ESG.

If we compare the KLD fund to the exchange-traded fund SPY, which tracks the benchmark S&P 500, we see that the KLD fund tracked the SPY fund nearly perfectly over the past six years. KLD, which like Maala was launched at the beginning of 2005, averaged annual returns of 2.4%, while SPY averaged 2.6%. KLD returned 15% over the past six years, while SPY returned 16%. Part of the difference is because KLD has higher management fees.

In a twist of humor and entrepreneurship, the company USA Mutuals launched the VICEX mutual fund at the beginning of 2005, too. That fund's name is no coincidence - it was introduced as an antithesis to all the do-gooder funds. It invests in companies that sell cigarettes and alcohol, profit from gambling, damage the environment (oil drilling, for instance ) and deal in arms.

It turns out that when compared to SPY, VICEX was considerably more volatile. But over the past six years, investing in vice paid off more than investing in virtue. After fees, the VICEX returned an annual 2.9% and a total of 18%, beating out SPY's 16%. Given that VICEX's annual fees of 1.8% are significantly higher than SPY's 0.1%, it's fair to say that the vices outperformed the S&P 500.

So does this mean investors should steer clear of socially responsible companies? To answer that, we need to know what's behind the various indexes' returns.

We'll find out by breaking down performance based on business sector.

I SPY with my little eye

The KLD social responsibility fund has a similar sectoral distribution to the S&P 500. All industries included in the S&P 500 are represented in the MSCI social responsibility fund, and all have an equal weight.

VICEX, in comparison, concentrates on consumer goods, consumer services and industrial materials. In periods when these sectors did better than others - such as after the prices of oil or basic food-industry inputs increased - VICEX also showed higher returns. (Obviously VICEX's past performance says nothing about its future returns. )

However, the fact that MSCI's social responsibility index mirrors the sectoral breakdown of the S&P 500 means that the KLD fund's returns were almost identical to the SPY fund's. This will ensure that KLD and SPY will have nearly identical returns in the future, too.

Comparing the sector breakdown of the Maala index to the TA-100 as a whole paints a fairly similar picture. Some sectors - industrial investment, gas exploration, financial services, computers and wood products - have no representation in Maala. Real estate, investment and holding companies are underrepresented, while services, insurance, electricity and electronics are overrepresented.

Therefore, we can say that Maala's returns dragged behind those of the TA-100 not because Maala is somehow inferior, but because the sectors with heavier representation in the do-gooder index didn't do as well as other sectors over the past six years.

Investing in socially responsible companies is a moral decision. But it's not an investment strategy, and it can't serve as a replacement for one. Investors need to choose assets based on proper distribution, low correlation between assets and the desired risk level.

If you want social responsibility indexes in your portfolio, do it in a way that conforms with your investment strategy.

Therefore, an investor seeking exposure to the U.S. market who wants to invest in socially responsible companies could invest in the KLD fund. This fund imitates the more general SPY fund nearly precisely because the MSCI USA ESG Select Index has the same sectoral breakdown as the S&P 500.

However, an investor seeking exposure to the Israeli capital market who chooses a Maala-based fund will receive returns unequal to the TA-100 because Maala SRI and the TA-100 have different sectoral breakdowns. To turn the Maala SRI index into a key tool for Israeli investors, the nonprofit Maala and the Tel Aviv Stock Exchange should consider weighting the index much the way MSCI does.

The writer is an economic adviser and the editor of the website INBEST. This article should not be taken as investment advice or as a recommendation to buy securities.