Can Socially Responsible ETFs be Fiscally Responsible?

Social responsibility is the phrase du jour. What about socially responsible investing? A plethora of ETFs with distinct approaches to socially responsible investing (SRI) are available. An investment in these ETFs may not just be good for the soul, it may begin to make sound fiscal sense too.

Over the last decade socially responsible investment has mostly looked fiscally irresponsible. Alternative energy ETFs have underperformed conventional oil and oil service funds and notorious carbon polluters in the power generation business. The so-called SINdex, composed mostly of alcohol, tobacco and gaming companies, has beaten the benchmark S&P 500 Index almost every year for a decade.

But this long-term trend may be under attack. Concern about the environment is heating up. Public disgust with corporate malfeasance is a daily story. And an ambitious administration with a new social agenda is advocating increased environmental regulation and providing record funding for energy alternatives.

The chart below compares 1-year returns of several important socially focused funds with the benchmark Standard and Poor's Depositary Receipt (AMEX:SPY).

The chart shows four ETFs: iShares KLD Select Social Index (NYSEArca:KLD), Van Eck Market Vectors Environmental Services (NYSEArca:EVX), PowerShares WilderHill Clean Energy (NYSEArca:PBW), PowerShares Global Clean Energy (NYSEArca:PBD), and an ETN: the iPath Global Carbon ETN (NYSEArca:GRN) compared to the benchmark SPY. The chart shows KLD and EVX closely tracking the SPY. The others are underperforming.

KLD from a market-targeting perspective is the least ambitious of these funds. Its holdings are 200-300 companies chosen from the S&P 900 Index. Companies for inclusion are chosen based on a comparatively superior record of environmental, social and corporate governance relative to their peers. Chevron, Microsoft, and AT&T are in the top ten holdings. For the SRI purist, an oil firm, a monopoly technology provider and a forcibly restructured media company may not suggest respectively the best environmental, social and corporate governance record out there. But an investment here as opposed to the SPY for example may make a statement that good behavior is being rewarded. Despite a higher expense ratio (0.50% compared to 0.08% for the SPY) the fund tracks, and almost certainly will continue to track, the benchmark.

EVX bills itself as an investment in the environmental services industry. Another way to say this is waste. Owning EVX is owning a stake in companies that dispose of everything from household garbage to medical and radioactive waste. It's biggest holdings are Waste Management (NYSEArca:WMI) and Republic (NYSEArca:RSG), which are mostly conventional nonhazardous disposal, and Stericycle (NasdaqGS:SRCL), which gets into more regulated waste products from hospitals, blood banks, pharmaceuticals and the like. Though EVX also tends to trade the benchmark, it has at times larger deviations in comparison with KLD.

The other two ETFs shown in the chart above, PBW and PBD, are more tightly focused than KLD and more high-tech than EVX. In fact, PBW is rapidly becoming the benchmark for alternative energy investment in the United States. PBD is its globally-focused sibling. Firms in these ETFs mostly focus on new technology and environmental innovation and have exposure primarily to the industrial materials, hardware and utilities sectors. Investors like PBW and PBD in part because they simplify the task of finding and vetting alternative energy providers and technology innovators.

PBW and PBD hold companies that aim to be cost-competitive with fossil fuels but in general are not yet competitive and therefore dependent on government subsidy. Yet because of the perceived opportunity in these technologies PBW and PBD typically have higher P/E ratios (about 15 as compared to 10 for KLD), and are much smaller, with an average market cap of about 2 billion compared to about 20 billion for KLD. Despite their expense ratios 0.66 for PBW and 0.75 for PBD, these are well-run funds and probably belong in any diversified energy portfolio.

The other fund shown in the chart above, GRN, is an ETN (Exchange Traded Note) rather than ETF. GRN tracks an index called the Global Carbon Index Return, which provide exposure to the price of carbon emissions. Right now it does this by tracking prices of carbon emissions credits in the European Union Emission Trading Scheme and Kyoto Protocol's Clean Development Mechanism. Though carbon emissions are of course global, most of the tradeable carbon is covered by these two schemes. GRN is set up to include additional carbon credit markets as they develop in the U.S. and elsewhere. U.S. programs are currently less developed than European counterparts, but they do exist and will probably become increasingly important under Obama. Today the regional Greenhouse Gas Initiative is the largest in the U.S. It includes power plants in ten U.S. states, but of course covers just a tiny fraction of total U.S. emissions.

The carbon market, both in the U.S. and Europe is in its early stages and tends therefore to be heavily policy driven. The price of carbon emissions in Europe is currently about $16/ton compared to about $2/ton in the U.S. This kind of difference, unthinkable for a typical commodity, has emerged because of the differences in the carbon permit or the cap-and-trade policies of the U.S. and Europe. Until policy objectives are sorted out GRN provides investors with a benchmark for assessing the progress of carbon emissions regulation and to a some extent the progress in the alternative energy industry more generally. Clearly as carbon reduction policies are implemented, the price of a unit of carbon emissions is expected to rise (U.S. carbon futures prices trade as high as $10/ton for 2015) and with it the price of GRN. But given the political and legislative complexity it is probably too early for most investors to do more than watch this.

One caution about GRN: unlike ETFs, ETNs have no direct holdings. Instead they are structured to correspond to the value of an index. They are essentially a promise to pay backed by the credit of the issuing bank, in this case Barclay's PLC. ETNs in other words have counterparty risk, which until the collapse of Lehman Brothers wasn't something investors worried about much, but since then has to be given some consideration. (Normally ETFZone avoids ETNs due to counterparty risk, but in this case, both because it is unique in the space and because it provides an helpful benchmark, we think this fund is worth a look).

A new competitor to GRN is the recently launched ETF AirShares (NYSEArca:ASO) from Xshares Advisors. Unlike GRN, ASO has actual holdings, namely futures contracts on the European Climate Exchange. Like a commodity-based ETF, when the contracts expire (in December of each year), ASO simply rolls them over. ASO has not really caught on with investors yet so it is still too thinly traded to be recommended here. But if it gets going this may eventually steal some business from GRN due to the counterparty issue associated with ETNs.

Within the alternative energy there are a number of sub-sector ETFs, like Claymore/MAC Global Solar Energy (NYSEArca:TAN), First Trust Global Wind Energy (NYSEArca:FAN), and Market Vectors Nuclear Energy ETF (NYSEArca:NLR), which focus on solar, wind and nuclear power respectively. A few of the holdings in these funds are big companies that can be found in the more general alternative energy funds PBW and PBD-- established firms like Vestas Wind Systems (NasdaqGS:VWS) and First Solar (NasdaqGS: FSLR)-- but most are small cap stocks working on new approaches and new technologies. Some of these smaller players may live or die by regulatory and funding decisions. For investors who don't mind the volatility, an ETF might be the way to gain some exposure to these focused sectors. But because they are highly speculative, we would encourage at most a very modest investment in these very focused ETFs.

SRI and alternative energy ETFs have chronically underperformed their less politically correct brethren. The combination of a new administration with a socially-oriented agenda and lower relative valuations for companies in the sector suggests that this trend may not hold.

A list Social Responsible Investment and Alternative Energy ETFs and annual expense ratios follows:

Responsible Companies

iShares KLD Select Social Index (NYSEArca:KLD) 0.5%

iShares KLD 400 Social Index (NYSEArca:DSI) 0.5%

Environmental Services

Van Eck Market Vectors Environmental Services (NYSEArca:EVX) 0.65%

Alternative Energy

PowerShares Wilderhill Clean Energy Portfolio (NYSEArca:PBW) 0.60%

PowerShares Wilderhill Progressive Energy Portfolio (NYSEArca:PUW) 0.60%

First Trust NASDAQ Clean Edge (NasdaqGM:QCLN)0.60%

PowerShares Cleantech Portfolio (NYSEArca:PZD) 0.60%

Global Alternative Energy

Van Eck Market Vectors Global Alternative Energy (NYSEArca:GEX) 0.65%

PowerShares Clean Energy Portfolio (NYSEArca:PBD) 0.75%

Solar Energy

Claymore Global Solar Energy (NYSEArca:TAN) 0.65%

Van Eck Market Vectors Solar Energy (NYSEArca:KWT) 0.65%

Wind Energy

First Trust Global Wind Energy Fund (NYSEArca:FAN) 0.60%

PowerShares NASDAQ OMX Clean Energy (NasdaqGM:PWND) 0.75%

Nuclear Energy

Van Eck Market Vectors Nuclear Energy (NYSEArca:NLR) 0.65%

PowerShares Global Energy Portfolio (NYSEArca:PKN) 0.75%

Carbon Emissions

iPath Global Carbon (NYSEArca:GRN) 0.65%

ASO AirShares E.U Carbon (NYSEArca:ASO)

Global Warming Companies

Credit Suisse Global Warming ELEMENTS ETN (NYSEArca:GWO) 0.75%