Are Green Funds True to Their Colors?

By Marc Gunther
Fortune

Socially responsible mutual funds have become big business in recent years. But some of their holdings may surprise you.

Imagine that you care deeply about the environment and that you want your investments to reflect your values. You might turn to the Sierra Club Stock Fund, a two-year-old mutual fund that promises to "invest for sustainable growth." (Pun intended.) The trouble is, the fund does not own shares in a single company that promotes alternative energy, organic farming, or other solutions to environmental problems. Most of the companies it does own--including Best Buy, Costco, Hershey Foods, Outback Steakhouse, and real estate investment trusts--do not even report publicly on their environmental practices.

Alternatively, you might consider Pax World Funds, another socially responsible fund company, this one started by religious opponents of the Vietnam war in 1971. In its advertising, Pax World employs such slogans as "green not greed," "conserve earth's resources," "no weapons," and "restore ecosystems." But its holdings include oil and gas industry firms Apache Corp., Baker Hughes, Carbo Ceramics, Chesapeake Energy, and Smith International, which most green funds screen out. Not one of those companies publishes an environmental or social responsibility report.

Do feel-good mutual funds deliver less than they promise? Their assets are growing slightly faster than the mutual fund industry as a whole--up by 156% over the past five years, to $31.9 billion, according to fund analyst Lipper. But critics, led by Paul Hawken, the author, environmentalist, and entrepreneur, say that the idea of "socially responsible investing" (SRI) has been stretched so far that it has become meaningless. In a blistering 35-page report that has roiled the SRI world, Hawken and his Natural Capital Institute say the industry has "no standards, no definitions, and no regulations other than financial regulations."

Feuding is nothing new in the SRI industry, of course. The subjectivity involved in marketing a moral standard--particularly when it applies to money-making--naturally leads to finger-pointing from time to time. And Hawken, it turns out, has plans to start up a fund of his own soon in partnership with a money-management firm called Baldwin Brothers. So he's hardly without motive to find fault with future competitors. Still, the questions he raises are provocative.

Hawken surveyed more than 600 SRI funds, most in Europe and Asia, and found that some held shares in Exxon Mobil, Wal-Mart, Halliburton, and Altria--companies often criticized by interest groups. Other major holdings of SRI funds include Microsoft, General Electric, and Citigroup. "The cumulative investment portfolio of the combined SRI mutual funds," Hawken says, "is virtually no different than the combined portfolio of conventional mutual funds." (The SRI industry now has something else in common with regular mutual funds. In late January, Pax World disclosed in a letter to shareholders that an internal investigation revealed that market timing had occurred in its Pax World High Yield fund.)

SRI money managers reject that accusation. They say Hawken's report mistakenly lumps together hundreds of funds from around the world, with widely varying standards and practices. "He's wrong in implying that the leaders in SRI funds would own Exxon Mobil or Wal-Mart," says Tim Smith, chair of the Social Investment Forum, an industry group.

Behind the charges and countercharges lie some thorny questions. What is a socially responsible company? And how do social investors best effect change?

Even in the SRI industry, there's no consensus around those issues--far from it. Most, but not all, SRI funds screen out stocks of tobacco, alcohol, gambling, weapons, and nuclear-power firms. That reflects their religious roots as well as the belief that too much of any of those products is bad for society. The big, mainstream, secular SRI funds also tend to tilt to the left--pushing for labor rights and affirmative action, for example. The major U.S. SRI fund families, such as Domini and Calvert, deploy relatively rigorous screens that eliminate between 35% and 50% of S&P 500 or Russell 1000 companies from their portfolios. (Performance of SRI funds varies widely, but as a group their returns are no better or worse than other actively managed funds.)

Other SRI funds reflect different beliefs. The Ave Maria Catholic Values fund, which describes itself as "morally responsible," screens out companies that support abortion, contraception, and pornography, as well as those that "undermine the sanctity of marriage." It dropped Eli Lilly from its portfolio after the company offered domestic-partner benefits to its workers, and it won't hold Wal-Mart shares because the company sells condoms.