Backing Your Beliefs: Socially Responsible ETFs Are on the Rise

In an economic downturn, you might expect risk-averse investors to stick to tried-and-true investments boasting strong financial fundamentals. But there are signs that a small but growing number of investors are backing their beliefs, instead of just the bottom line.

One example is the increase in socially responsible and faith-based exchange-traded funds, or ETFs, which invest in an entire index of stocks chosen -- in this case -- for their companies' social, environmental or moral principals.

Joseph Witthohn, an investment analyst with Janney Montgomery Scott, says he's seeing a "sudden interest" in two subsets of socially responsible investments, or SRI, in particular: Green and faith-based investing. At least 17 alternative-energy ETFs exist today, compared with just eight screening for positive social and environmental practices at the end of 2007, according to Deana Arnett, senior planning consultant at Financial Planning Services. And at the end of 2009, FaithShares launched five faith-based ETFs that select stocks aligned with Christian beliefs.

Gen X Crowd Wants A Greater Say

What's fueling the growth of SRI? As interest in the environmental and alternative-energy rises, interest in investing in those areas also is increasing. "The global phenomenon of environmentalism and social justice is starting to grow, so people realize there is money to be made by investing in companies that cater to those industries or companies that are on the cutting edge of those philosophies," says Garrett Stevens, CEO of FaithShares. "Many younger people, such as the Gen X crowd are starting to have more dollars to invest and want to have a greater say in what companies they invest in."

Investors need to feel they are doing something positive, whether it's for the environment, the community or their families, Arnett says. And as the demand for these investments grows, offerings also are becoming more attractive, she added. "There are quite a few attractive investments that didn't exist just a few short years ago."

So far, alternative energy has been one of the hottest sectors within socially responsible ETFs, she says. "President Obama's administration has committed dollars to funding this sector over the next decade, so optimism is running fairly high that 'clean energy' stocks and funds will benefit," she says.

A 'Tiny Part' Of The Universe

Make no mistake, ETFs still make up a tiny part of the $2.7 trillion universe for socially responsible investments, or SRI, which represents one out of every nine dollars invested, Arnett says. Outside of "green energy" ETFs, which make up close to $2 billion and growing, the total is only around $250 million, Witthohn estimates.

But as the marketplace for specialty or niche products continues to grow, some industry insiders predict that socially responsible ETFs could be the next big thing. As the SRI field begins to mature and the needs of the investing community become more crystallized, ETF providers will be right there to provide products, Stevens says.

The advantages of socially responsible ETFs are similar to those of ETFs generally -- liquidity, low cost, tax efficiency, interday trading and transparency. That said, socially responsible mutual funds and ETFs tend to have higher expense ratios than their less ideologically driven counterpoints, which often translates into lower investment returns over the long term, says Shomari Hearn, a certified financial planner with Palisades Hudson Financial Group. "SRI mutual funds and ETFs have not been in existence for very long, compared to traditional index funds, so the verdict is still out," she says.

Performance Of Funds Vary Widely

However, Stevens points out that FaithShares' ETFs have an expense ratio of 87 basis points and the KLD Social Fund (KLD) has a ratio of 50 points, which make both of those funds much less expensive than SRI mutual funds such as Calvert Large Cap Growth (CLGAX) which comes in at 150 basis points. The performance of the different funds vary widely, but ThomsonReuters' Lipper service on March 1 ranked FaithShares Funds as four of the top 10 large-cap growth funds, our of 899 similar funds, he adds.

While the idea of social responsible investing is to avoid benefiting from the success of "unethical" or "immoral" companies, Hearn argues that investors can do more good in other ways. "Donate some of your investment returns to charities or causes that do meet your values," he says. "You can better demonstrate your lack of support by not buying those companies' products or services, which has a direct effect on their bottom lines."

Then too, an ETF may not be the first choice for the SRI "purist," as actively managed mutual funds are better able to exclude stocks that no longer meet the criteria, says Arnett. "ETFs, by design, should own the same stocks one year from now that they hold today," she says. "For the SRI investor, the ability to exclude stocks that no longer meet the criteria is extremely important."

Lower Advocacy In ETFs

In addition, advocacy tends to be lower in ETFs than in mutual funds, says Day, who added that he not aware of any ETF sponsor who is active in shareholder advocacy. "This is something you give up versus an SRI mutual fund, and advocacy is a big thing for SRI investors."

In spite of all these challenges, Witthohn forecasts that investment in socially responsible ETFs will pick up soon. "Once the stock markets have settled down a bit, investors will move SRI ETFs off the back burner and increase their focus in this important area," he says.

Stevens also expects an explosion of SRI and faith-fased ETFs in the near future. "Large pension plans such as the CalPERS of the world will continue to look for additional ways to pressure companies into doing good things, or to be better stewards of the environment and various social causes," he says. "As people continue to tire of corruption going on in corporate America, they will turn more to investments that allow them to have a say in the companies they do business with."

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