In This Chapter

There is an ongoing war in the mutual fund industry between the investment professionals who believe it is possible to selectively pick stocks that will outperform the market and another group that says the market will win in the end. The index mutual fund is the latter group’s answer: you don’t try to beat the market; you mimic it. That’s not the whole story of index funds, but by definition, they are created to match or mimic a market index.

Indexes are usually created to track a specific market or segment of the market. Index mutual funds are organized to mimic the market so investors can participate in the performance of that market or market segment. In the traditional mutual fund world, index funds have very low expense ratios. If they are managed correctly, the fund’s performance will parallel the movement of the index. This gives investors the opportunity to passively share in the gains or losses of this market or market segment.

For SRI mutual funds, the same index fund concept is true. The difference is SRI mutual fund indexes must be screened or they will not be any different from traditional indexes. This meant new indexes had to be created or existing ones substantially modified.

In the world of traditional mutual funds, the best-known index is the S&P 500 index. It is a broad-based selection of 500 leading stocks and is considered a proxy for the whole stock market. Many traditional mutual funds compare their results to the performance of the S&P 500 index. If the fund can show a higher percentage growth than the S&P 500 index, the fund manager can boast of “beating the market.” Other indexes cover different segments of the market, some larger and some smaller.

Indexes are model markets constructed to track the performance of the whole market or a segment of it.

To better follow SRI index funds, it is helpful to understand indexes and how they work. Not all indexes are created the same. How the value is calculated can make a big difference in when market movement affects its total.

An index of stocks (or bonds) is a mathematical exercise in grouping stocks to be tracked and deciding on how the index will be calculated. Several methods of calculating changes in an index exist. In the next section, we’ll look at two different methods.

In simple terms, an index begins with a value and then tracks the changes in prices for the stocks making up the index. As each stock changes price, the index is recalculated based on the method chosen and a new index value is posted. During the trading day, this is done in real time. Stock splits, dividends, and other events are accounted for in the index recalculation. Occasionally, companies are dropped from the index and new companies added. The index is adjusted accordingly.

The S&P 500 index is the most widely used index by investment professionals as a proxy for the whole market, but it is not the best-known index to the public. That honor belongs to the Dow Jones Industrial Average, better known as the Dow. While the S&P 500 tracks 500 stocks, the Dow covers just 30. The Dow has been around longer and carries much more emotional appeal than the S&P 500. Investment professionals view the Dow with caution, but respect the fact that it represents the mood of institutional investors who hold most of the stocks in the Dow. Their actions (buy or sell) can drive the whole market either up or down.

The Dow is 30 of the largest blue chip stocks on the market. These companies are the rock-solid leaders in their industries and represent the safest of equity investments. While no stock investment can be considered completely safe, these companies represent conservative investments, which is one reason most of their outstanding shares are owned by institutional investors. The Dow is a price-weighted index, which means a change in price for any component of the Dow affects the index the same. For example, a stock selling for $20 goes up $1 in price and a stock selling for $40 goes up $1 in price. Both price changes would have an equal affect on the index.

The S&P 500 has 500 of the leading companies in its index. Most of them are large-cap stocks, but not all. Because it covers a much broader segment of the total market, it is considered a total market index. The S&P 500 is a market-cap weighted index, which means more importance is given to larger companies than to smaller companies in calculating changes to the index. A $1 change to Microsoft will count much more than a $1 change to a smaller company. This skews the results toward large companies, but the index is still representative of the broad market—it covers about 70 percent of the total market’s value.

The traditional mutual fund market is extremely competitive and produces new indexes and new funds on a regular basis. In addition to the broad market indexes such as the S&P 500 and the Dow, a number of stock sector indexes track a narrow segment of the market—for example, technology stocks or energy stocks. These sector or segment indexes let investors follow a particular industry or segment of the economy by buying the leading companies through the index fund.

As we noted in Chapter 14, traditional index funds can be quite inexpensive to operate and are often offered with expense ratios as low as 0.25 percent. Because they are passively managed, the funds have very low expenses and can keep costs down. This is a powerful argument for investing in index funds exclusively.

Socially responsible index mutual funds follow the same principles as traditional index funds with the exception that a screening process of some type creates the index. SRI indexes range from broad market coverage to a more narrow focus. The main concern is what is screened in and what is screened out. These decisions define the index and the index fund.

A criticism of SRI indexes and index funds is that some are contrived and may not represent a true value to the shareholders. Another criticism is that some indexes were created to make SRI investing more appealing to institutional investors who own most of the total assets invested in socially responsible funds.

Most indexes keep the list of members out of public access areas, although you can usually buy a copy. The important thing for SRI investors to remember is that multiple screens create indexes and it is important to know what goes into those screens so you can judge how “socially responsible” the members of the index are.

The growth of the SRI mutual fund market has given rise to the need for more indexes to measure different segments of the SRI market. This coincides, somewhat, with the growing interest in traditional index mutual fund investing as a low-cost alternative to actively managed funds.

Some influential names in investment research have joined the industry with SRI indexes of their own, which adds to the creditability of the movement. But there are still indexes on the market that seem to have been created by organizations with little background in indexes or investment management. Because SRI indexes are inherently subjective in how and what screens are applied, investors should be cautious when investing in index funds.

The first SRI index was the Domini 400 Social Index started in May of 1990. It was an answer to the S&P 500, but not a duplicate of that index. The Domini 400 consists of 400 socially screened companies. KLD Research & Analytics created the index to provide a way for SRI investors to measure their performance. It also demonstrates the affect of social, environmental, and governance screens have on the risk/ reward equation.

The Domini 400 is a float-adjusted, market cap weighed index. It is similar to the S&P 500 in that changes in larger companies count more than changes to smaller companies’ stock prices. It differs in that the index uses a float-adjusted basis rather than outstanding shares to judge a stock’s market capitalization. Float adjusting means the index only counts shares of stock that are actually available for trade. It does not count shares of stock held by founders, a control group, or others that are not generally available on the open market. KLD Research believes this makes the index a more reliable indicator of market conditions.

KLD Research licenses use of the index to mutual funds and exchange traded funds that want to build a product on it. Up until November 30, 2006, the Domini Social Equity Fund was the largest and oldest socially responsible index fund in the industry. On that date, the fund transitioned to an actively managed fund. (More on the Domini Social Equity Fund in Chapter 16).

Although the Domini 400 serves the same purpose as the S&P 500, it is not a mirror or substitute for that index. Only 250 of the 400 firms in the Domini 400 come from the S&P 500. Of the remaining, 100 are mid-cap stocks and 50 are small cap stocks. According to the KLD Research website, this is the performance of the Domini 400 index relative to the S&P 500 index:

Because the Domini 400 index is more heavily represented in the technology and financial services sectors than the S&P 500, it will show better returns during those periods when those sectors are doing well. But the index excludes many energy companies, industrial concerns, tobacco firms, and others, so it will not do as well when its core sectors turn down as they did following the tech crash in 2000.

You cannot invest directly in the Domini 400 Social Index because it is not a security. The index is licensed to investment companies for use in building investment products such as mutual funds and exchange traded funds. The Domini 400 is licensed to Green Capital Management for use in its Green Century Equity Fund. The fund is a stock index fund based on the Domini 400. According to fund information, its objective is:

The Green Century Equity Fund seeks to achieve long-term total return, which matches the performance of an index comprised of the stocks of 400 companies selected based on social and environmental criteria. The Fund seeks to achieve its objective by investing in the stocks, which make up the Domini 400 Social Index.

According to a prospectus dated November 28, 2006, the Green Century Equity Fund had a total operating expense ratio of 0.95%. Based on information from the Green Century Funds website (www.greencentury.com), here is how the fund compared to the S&P 500 in returns over several periods.

Green Capital Management is typical of many SRI investment companies that combine investing and shareholder advocacy. In addition to the Green Century Equity Fund, the company offers the Green Century Balanced Fund. Contrast this with traditional mutual fund companies that may offer dozens of funds in the same family. A group of nonprofit organizations dedicated to environmental issues owns the company. According to the Green Century Funds website, all of the profits earned by the management company go to these nonprofit groups to further their goals of supporting a variety of environmental issues.

Although not as well-known as the broad market indexes, some smaller indexes cover very specific parts of the SRI spectrum. These indexes focus on certain parts of SRI investing that may appeal to particular investors. One example is The Wilderhill Clean Energy Index (www. wilderhill.com). The index philosophy is:

This index is obviously very narrow in its focus, as opposed to the Domini 400, which took a much broader look at the SRI market.

You cannot invest in this index directly, but an exchange-traded fund, The PowerShares WilderHill Clean Energy Portfolio, that mimics the index is available. Exchange traded funds are similar too, but not the same as mutual funds. At the end of this chapter is a discussion of SRI exchange traded funds.

The evolution of socially responsible index funds followed the same logic that propelled the growth of traditional index mutual funds. Investors were looking for an inexpensive way to buy “the market” or a well-defined part of the market. Traditional index funds were developed along with a variety of parameters including market breadth, company size, economic sector, and so on. SRI index funds use some of these same parameters, but they also layer on their social, environmental, and governance screens. Thanks to modern screening tools and proprietary research databases, investment management companies can construct indexes based on a wide variety of financial and SRI parameters. This gives SRI investors a relatively large choice of funds to consider. It is important for investors to exam each SRI fund, including index funds for it sector representation and actual holdings. If you are not careful, you may end up with several funds that essentially own the same stocks.

As noted above, the Domini Social Equity Fund was the first and for many years, the largest SRI index fund before converting to an actively managed fund in 2006. Before its conversion, the Domini Social Equity Fund was a huge player in the SRI market (it remains so, after its conversion) . Since the 1990s when the Domini Social Equity Fund was started a number of other index funds have sprung up, including some from among the most respect names in the traditional mutual fund world. Their entry into the SRI market and index funds proves that socially responsible investing is not a passing fad but a legitimate part of the financial scene.

One of the most respected names in SRI mutual fund investing is Calvert, which has developed one of the best management teams for its funds. Calvert offers its own SRI index called the Calvert Social index. The index contains 641 companies that have been screened for social, economic, and environmental concerns. The companies are large-cap growth stocks.

This index is used to form the Calvert Social Index Fund, which is a large growth fund. The fund begins with the top 1,000 firms and begins a rigorous screening process, according to its website to weed out the unacceptable stocks. The fund mimics the index and adds or deletes stocks as the index does. With an expense ratio of 0.75%, the fund is competitive with traditional index funds as well as SRI index funds. A mutual fund industry giant, Vanguard has a SRI index fund based on the FTSE4Good US Select Index, which a London-based, U.S. version of a global index of socially responsible companies. Vanguard had been using Calvert’s Social Index up until the end of 2005 when it switched to the FTSE4Good US Select Index to pattern its Vanguard FTSE Social Index Fund. Vanguard is a leader in low-cost index funds and this fund at 0.25 percent expense ratio is no exception.

Although the Vanguard fund is categorized as a large-cap growth fund, it does have some mid-cap stocks in its holdings. The fund holds 425 stocks. Compare the economic sector holdings with the Calvert Social Index Fund and the S&P 500 index.

Both Calvert and Vanguard are large-cap growth funds, however, because they use a different index to constitute their funds, the holdings by economic sector show some distinct differences. Vanguard is clearly more heavily weighted toward financials, while Calvert is spread more evenly between financials and information technology. This difference doesn’t make one fund bad and the other good, but it does mean that under certain market conditions one funds may register a stronger return than the other. Contrast both funds to the sector weighting of the S&P 500 index, which has no socially responsible screening. You can see that while the two SRI funds address a broad market, they do not come close to duplicating the S&P 500 in their representation of the economic sectors. Both Calvert and Vanguard have over two-thirds of their investment in Health Care, Financials, and Information Technology. The S&P 500 has only 48 percent in the same three sectors.

Exchange traded funds (ETFs) are relatively new investment products that have caught on with some investors. ETFs are very much like index mutual funds. In fact, ETFs track stock and bond indexes just like index mutual funds do. But ETFs differ in some significant ways from mutual funds. These differences may work to your favor or not, depending on the type of investor your are and what your investment goals are. ETFs allow you to buy a basket of stocks just like an index mutual fund does. The major difference between ETFs and mutual funds is how they are bought and sold.

Exchange traded funds are bought and sold just like shares of common stock on the stock exchanges. Their prices change continuously during the day as the underlying stocks change in value and the supply and demand for the ETF shares pushes the price up or down. You buy ETFs on the open stock market just like you buy shares of common stock, which means you pay a commission to a stockbroker when you buy and when you sell. But an investor has no ongoing expenses to pay like an expense ratio in mutual funds. If you want to trade ETFs like stocks, you can. All the various stock market trading orders and strategies are available for ETF trading. You can buy 200 shares of an ETF in the morning and sell 100 shares back that afternoon if you wish.

Exchange traded funds track a variety of SRI indexes, from the Domini 400 Social Index to some very small and specific indexes. A rule of thumb, which is true for index funds as well as ETFs, is the more narrow and specific the index, the more volatile it may be. Without any other industry sectors to offset negative news, a narrowly focused index fund, or ETF can suffer a significant reversal.

Barclays Global Investors has an ETF that follows a KLD index fund with broad market coverage. The KLD Select Social Index is an SRI index designed for investors who appreciated the values of SRI investors, but wanted more diversification in their holdings, which generally means they were less risk tolerant. KLD created the Select Social Index by choosing several hundred large companies from all economic sectors, except tobacco. Rather than screen out companies for poor showings in one of the usual screens, KLD under-weights poor performers and over-weights companies that score well in its SRI screens. This gives investors the diversification they need. Barclays uses this index as the basis for their ETF they call the iShares KLD Select Social Index Fund. The term "iShares” is your tip that this is an ETF and not a regular mutual fund.

On the other end of the size and focus scale, PowerShares Capital Management is using The Wilderhill Clean Energy Index to produce its own ETF called PowerShares WilderHill Clean Energy Portfolio. This ETF covers 37 companies that support and produce cleaner energy production.

What are the advantages of ETFs over index funds? You can use a variety of stock trading tools and strategies that are not available to index mutual fund investors, and if you are investing in a highly volatile sector ETF, you may want that flexibility. In addition, there are no ongoing expenses that even no-load mutual funds charge. That may not mean much if you are comparing an index fund with a 0.25 percent expense ratio with an ETF bought from a discount broker, but if the index fund has a ratio approaching 1 percent it will make a difference for the long-term investor.

If you are not planning on trading, but holding for a long-term investment and can get a no-load index fund with a reasonable expense ratio, you will probably not help yourself by switching to an exchange traded fund.