Funds: vice or virtue?

By PHILIP MACALISTER

Managed funds come in all sorts of flavours these days. You can have one that invests only in New Zealand shares, one that covers the world, or one that invests only in some specialised sector.

Now, you can even put your money into a "vice fund".

The vice fund has been introduced in the US as a counter to the growing number of "socially responsible" or "ethical" investment funds.

The idea behind socially responsible investing (SRI) is to put money into companies which "do good" - businesses which treat workers fairly, minimise their environmental impact and aren't bad for people's health.

SRI is a significant trend around the globe, particularly in Europe and the US. In Australia it appears to be making progress as an investment option and there is a growing awareness, if not investment, in this area in New Zealand.

So what is a vice fund? It's the opposite of an SRI fund, investing in companies which make things that kill (guns and armaments), and the social vices - alcohol, tobacco and gambling.

A Texas online advisory firm, mutuals.com, is promoting its Vice Fund, which is expected to be added to the Nasdaq exchange soon.

On its website, the company says: "Although often considered politically incorrect, these and similar industries and products ... will continue to experience significant capital appreciation during good and bad markets. We consider these industries to be nearly recession-proof."

It produces some research which suggests that doing bad is actually good - financially at least.

To push its point, the company says if it had simply divided a portfolio equally among four sectors - alcohol, tobacco, gaming and casinos and aerospace/defence - over the five years from June 30, 1997 to this year, it would have "significantly outperformed the S&P 500 index".

"We believe that these sectors, regardless of bull or bear markets, will continue to experience significant capital appreciation," it says.

The bad news for politically incorrect investors is that vice funds are not exactly a mainstream option, and are unlikely to achieve the popularity that SRI has enjoyed.

Arguably, the fund is little more than a gimmick.

But the "research" used to support the vice fund raises a question: how well do SRI funds do, and have they performed any better than mainstream managed funds?

Plenty of studies have been done on this question and the majority of the papers produced, even by people who don't support SRI, say that investing responsibly does not mean any significant reduction in returns.

William M. Mercer head of research Frank Jasper says that of the 21 empirical studies on SRI, 12 said it had a positive effect on returns, one said it was negative and the rest said an SRI strategy was neutral.

A comparison of SRI indexes, such as the Dow Jones Sustainable Global Index and the Domini 400, against broader indexes, such as the MSCI and S&P 500, also show that over the past couple of years there has been little difference in returns.

But, says Jasper, "SRI indices tend to have a higher risk than their traditional counterparts."

There is also some research, though, which says the returns on SRI funds, as opposed to indexes, have come with lower risk levels than conventional funds have achieved.

Perhaps the big issue is that the pattern of returns can differ from the index.

Jasper says SRI funds have a tracking error - the difference between a fund and the index it is meant to track - of about 4 per cent, slightly lower than most actively managed New Zealand equity funds.

Because of this, investors in SRI funds can expect similar returns to the index, but "the pattern will unfold differently".

"SRI investing is neither a cost nor an opportunity," he says. "But there are different performance pathways that you need to understand when you build an SRI strategy."

A piece of preliminary work by the Institute of Actuaries in Australia also suggested that SRI was good in more ways than one.

"Our initial analysis indicates that SRI funds appear to have generated outperformance in Australia," PricewaterhouseCoopers actuary David Knox says.

The outperformance was about 1.3 per cent a year for three years.

He says SRI companies may be more profitable than other companies because they have lower compliance costs, enhanced brands, save money through the efficient use of resources, energy and materials and have improved environment risk management procedures.

Knox also suggests that the growing popularity of SRI strategies may have a positive impact on share prices.

"There may be a boost to short-term performance driven by demand," he says.

However, he adds, this outperformance may be a short-term phenomenon. "As soon as any undervaluation is factored in [to share prices], outperformance will end and investing in SRI will actually cost investors in financial terms."

But the financial impact is not the only thing to consider when evaluating returns from SRI.

Knox says the idea of any product is to maximise customer satisfaction after buying it. While returns are one thing, people who buy SRI funds may also consider that the "feel-good factor" is also part of their return.

But other, less comforting, research has recently come out of Australia.

The University of Melbourne produced a paper which suggested that SRI investments would produce returns 0.7 per cent a year lower than mainstream investments.

This piece of research has been the basis of some heated argument in Australia. Leading SRI manager AMP Henderson disputes the university's findings; its research suggests that the median SRI manager outperformed traditional asset classes in the past three to five years by up to 2.5 per cent.

But international consultancy firm Frank Russell doesn't use SRI as a style of investing, partly because SRI reduces the pool of companies a manager can invest in, thereby increasing risk levels.

Whatever the arguments, New Zealanders are soon going to hear more about the SRI trend. The Government's new superannuation fund, set up to help pay part of the cost of future pensions, is required to invest in a responsible manner.

Likewise, there are a number of SRI funds already available in New Zealand - from mainstream products from AMP, Tower and Challenger, through to highly specific New Zealand offerings from organisations such as the Hawkes Bay-based Prometheus Foundation and Recycloans, on Auckland's North Shore.

In Australia, investors have many more SRI funds to choose from, and some managers across the Tasman may be about to launch their funds in New Zealand. And there are at least two UK-based listed investment trusts which have been promoted to New Zealand investors.

As yet, there are no vice funds available.

* Philip Macalister is the editor of online money management magazine Good Returns. Good Returns provides news on managed funds, mortgages, insurance, superannuation and financial planning. His email is philip@goodreturns.co.nz