Socially responsible investing: Can fund screens be trusted?

Somebody needs to be keeping a closer eye on those who aspire to hold companies to high ethical standards.

That's one of the key lessons observers are gleaning in the aftermath of a humbling episode for Pax World Funds of Portsmouth, N.H. The firm agreed this summer to pay a $500,000 penalty for having invested, over a four-year period, in companies that were off-limits because of their social and/or environmental practices. The case marked the first time the Securities & Exchange Commission had fined a socially responsible mutual fund for neglecting its own screening criteria.

Having caught one socially responsible (SR) mutual fund company in the act of failing to keep its promises, regulators at the Securities & Exchange Commission appear ready to find more.

"When we identify a risk area," says David Bergers, director of the Boston regional office of the SEC, "you can expect that we will be incorporating it into our examination oversight of funds."

But is government oversight enough to give investors peace of mind?

Investors have a lot riding on whether SR funds do as they pledge to do. If a fund takes more risk than advertised, for instance, a conservative investor could be surprised in a market downturn, such as mid-September's, to find a bludgeoned portfolio. And if a fund neglects to follow its social or environmental guidelines, then investors aren't getting the service for which they've paid higher-than-average expense ratios.

Some industry observers are taking heart in the prospect of more aggressive regulation of SR funds in years to come. But others are urging investors to be more proactive. Their prescription: Watch for a few telltale indicators of whether a fund has solid monitoring systems in place – or if it's vulnerable to a Pax-type lapse.

In certain circles, confidence in SR funds continues to run high. Justin Harris, a Seattle-based financial adviser with a specialty in SR investing, says he doesn't hesitate to plug investors into a range of SR funds, especially now that regulators seem to be paying fresh attention to the sector.

"I believe in the power of the spotlight," Mr. Harris says. "It brings attention to individuals, companies, and mutual funds [because] people all of a sudden say, 'We've got to make sure we get our act together now.' "

Some investors seem to share that sentiment. Seven of Pax's eight funds have seen a net inflow of investment dollars and an increase in investor numbers since the SEC settlement announcement on July 30, according to President and CEO Joe Keefe.

Not everyone, however, believes it's time to relax. The Pax debacle could serve as a useful wake-up call to investors who may have grown a bit complacent, according to David Wood, director of the Institute for Responsible Investment at Boston College.

"I don't think Pax is the only fund to ever have a screen slip," Mr. Wood says. "The news about Pax reminds people that they need to pay attention."

For individual investors, checking up on the practices of mutual funds could quickly become technical, tedious, and time-consuming in the absence of a few, easy-to-read indicators. Since the industry isn't a simple one to decipher, nonprofessionals shouldn't bother to do their own analysis of a fund's internal monitoring systems, according to David Tittsworth, executive director of the Investment Advisors Association, a professional trade group based in Washington, D.C.

"A lot of investors don't even bother to read fund prospectuses," Mr. Tittsworth says. "It's a pretty tall order for an armchair investor [to determine], 'Is the information, which you've just read and hopefully understood in a prospectus, questionable in any way?' "

But others argue such an in-depth analysis isn't necessary to ascertain whether a fund has solid safeguards in place. The alternative they recommend is to ask an investor-relations department whether certain structural features are in place or not.

One approach might be to look for systems like those now in place at Pax. As part of its deal with the SEC, Pax has introduced new monitoring tools that number among the most foolproof in the industry. Among the additions: a new, easy-to-read database that clearly indicates what's investable and what isn't; daily reviews of all transactions by an expanded team of compliance officers, who make sure no prohibited firms have landed in a fund's portfolio; and an automated trading system that blocks the purchase of any unapproved security.

Pax has also beefed up its social research department. There, staffers determine whether a company meets its social screens or not. Investors would always be wise to investigate whether a fund company does its own social research in-house because it's a sign of a "serious review" process, according to Tim Smith, director of socially responsive investment at Walden Asset Management.

Mr. Smith says investors could also ask: "How often do you review and evaluate companies that are in a process of change [to determine]if they're changing their character?"

Others, however, want to see more structural safeguards in order to feel confident. In-house social research runs a risk of being compromised when it's done by the same department that analyzes whether a stock or bond is a good buy, according to Paul Hawken, executive director of the Natural Capital Institute, a California-based nonprofit that's faulted SR funds for using lax screening methods. He says financial and social research should be strictly separate, just like editorial and advertising departments in newspapers, in order to be sure some companies are excluded – even when they're good candidates to deliver handsome returns.

"The performance pressures are so great that research gets diffuse and becomes almost meaningless" when research departments are combined, Mr. Hawken says.

Doing in-house social research, as opposed to buying lists of supposedly conscientious companies and investing in them, comes with pros and cons. A well-staffed social research arm can help ensure that investors' values are reflected in their portfolios, according to Brad Barber, director of the Center for Investor Welfare and Corporate Responsibility at the University of California, Davis. But research is expensive, he notes, and investors pay a premium – usually more than 1 percent of assets under management – to get such a vigilant internal monitoring system.

As a proponent of low-cost investing, Mr. Barber suggests an alternative strategy for ethically minded investors. Look for funds pegged to socially screened indices, such as the FTSE For Good Index or the Domini 400 Social Index. By relying on widely disseminated social research, as opposed to customized in-house research, investors can save a bundle while still enjoying peace of mind that comes with an active monitoring system.

"While I like the idea of thinking about values when we are saving for retirement, I'm also a little bit uncomfortable recommending that investors spend a lot of money on the expenses that are charged by [actively managed] funds," Barber says. "These socially screened indexes … are probably going to satisfy the values of a broad section of the population."