April 2006

Occasionally I am asked if we can avoid investing in a particular industry or a specific company. There are just some things we believe in and it is natural to want to support those things that support our value system and to disassociate ourselves from those that oppose our principles. I thought we might take a look at the real world implications of some of these decisions.

Let’s start with the assumption that you are investing a tidy $1,000,000 in a portfolio of 8 mutual funds. Each mutual fund, by law, must have a minimum of 20 holdings and most have many more than that. For simplicity’s sake, let’s also assume that your portfolio is divided equally among the different mutual funds and that each mutual fund invests 5% of its assets in each of 20 positions. Before we go any further, let me stress that this scenario does two things. One is that, it keeps the math simple, but the other is that it is unrealistically generous in favor of the amount of money that is likely to go into any one stock. How much of your money goes toward our unwanted stock (ticker symbol EVIL)? $6,250. That is it. Just $6,250 out of a $1,000,000 investment.

Let’s add insult to injury. What is a socially conscious mutual fund? Nobody knows because everybody has a different definition. One fund only invests in union employers; another may avoid gambling, and another nuclear power. There is no standard definition of what a socially conscious fund is.

Now let’s take a look at how your $6,250 supports the nefarious endeavors of the EVIL corporation. If EVIL has a market capitalization of $1 billion, your share of the company is 1/1000 of 1%. Most of the time when you are buying and selling stock you are not actually doing business with the company involved, but with other investors who are trading that stock. So your $6,250 has probably not gone to EVIL, but to another investor. There are advantages to the company in having a higher stock price. But your .001% has not likely had any effect on the stock price. If you don’t buy the stock, somebody else will, therefore you are not supporting the stock price in any significant degree. In real world, practical terms, what you can say for not having bought the mutual fund that invests in the stock of EVIL, Inc is that you are not associating yourself with the EVIL Corporation. And there is something to be said for that. We generally do not wish to be associated with those who do things we are opposed to doing personally. But what has this cost you and is there a better way to do more good?

Warren Buffet once supposedly said that the hardest thing to find is a good investment. It follows then, that when looking for a good investment you ought to give yourself as many opportunities to succeed as possible. Investing in socially conscious funds limits your opportunities in two ways. First, by limiting the investment selection within the fund itself, the fund manager may be overlooking opportunities. This is, however a trivial point compared to the other way you limit your opportunities. After all, it isn’t as though the only good investments available are gambling casinos. Here is the real issue. I was able to locate 71 mutual funds that have a 5-year track record and hold themselves out to be socially conscious investors. As indicated earlier we don’t know what socially conscious means to them. That compares with 12,210 mutual funds with a 5-year track record in the market at large. These numbers count multiple share classesof the same fund as separate funds, so in realistic terms, the numbers for both categories are somewhat smaller. What happens when you limit your universe from 12,210 to 71? You lose options. Of the 12,210 mutual funds I found with a 5-year track record, 689 of them had a better return than the best performer among the socially conscious funds and 7,723 had a better return than the average return of the socially conscious funds. But, you say, money isn’t everything. No it is not. But let’s talk about how we can do some real good.

What if you can invest in such a way as to earn just 1 percentage point more by investing for return rather than social reasons? Using a $100,000 investment (as opposed to the $1,000,000 in the earlier example) that earns you $1,000 more on your investment your first year. Donate ½ of that increased earnings to a cause that will make the world a better place. Next year, if your investment has made a profit you will have even more to donate. If you earn 9% per year you will contribute $2,962 over 5 years and $7,417 over 10 years. And your investment has grown to $208,385. Compare the good that can be done with $7,417 to what is accomplished by not owning stock in a corporation whose activities you disapprove.

If you had invested in a socially conscious manner and earned 1 percentage point less, you would have contributed nothing to your cause and your portfolio would be worth $199,900 after 10 years. And there is something poetic about using the profits made from EVIL, Inc to help cancel out their activities.

Of course you will not earn either 8% or 9% each year in any investment. You can expect to earn money some years and lose some years. Some years a socially conscious investment may earn more than another portfolio. But over time, based on the opportunities available and historic performance to date, it seems reasonable to expect that you can do more good for those causes you believe in, by making enough money to make meaningful financial contributions to those causes than you can by avoiding objectionable investments.

When you invest in a Portfolio Monitor account you are getting several things. One is my research and investment selection. That is, I evaluate the mutual funds in your portfolio on a regular basis to make sure that they are doing what we hired them to do. Changes are made from time to time as circumstances warrant. Another thing that you are getting is an asset allocation. That is, your portfolio is invested in a variety of asset classes in order to seek to maximize your return consistent with an acceptable level of risk.

You also get portfolio rebalancing. Different asset classes perform differently in different economic climates. So far this year small cap growth and value stocks have had double-digit returns, while bonds have lost ground. This creates distortions in your portfolio which we seek to exploit by selling off some of the winners, to take some profits and buying more of what hasn’t been doing as well, thus buying low and selling high. In this way we keep your portfolio in line with your risk tolerance and capitalize on the market’s quirks. It was previously thought that rebalancing once or twice a year was adequate. Recent research has shown that rebalancing more often tends to do a better job of capitalizing on market movements, thereby reducing volatility and increasing performance. As with all things in this business, there is no guarantee that will always be the case, but if we go with the statistics, we have a better chance of winning. As a result, you may have noticed more activity in your account. You should be seeing trades in your account at least every 60 days. Keep in mind that if you have more than one Portfolio Monitor account, I treat them as one portfolio, so you may see activity in one account this month and in another account at another time. But when we do this, we are rebalancing the entire portfolio.