Do Good Guys Always Come in Last? Socially Responsible ETFs

The financial crisis raises fresh questions about executive pay, corporate responsibility, capital stability and sustainability. Socially Responsible Investment (SRI) focusing on these areas has attracted as much as $2 trillion in capital. ETFs are a tiny part of the SRI universe. But SRI-focused ETFs are important because of their high profile accessibility, transparency, liquidity, and low cost.

SRI looks for companies that emphasize long-term planning, environmental green products, and ethical choices without sacrificing financial performance. Constructing a viable SRI index is no easy task because some of the best performers over the long run have been more associated with bad behavior than good behavior. Tobacco, major oil, and electrical utilities are classical whipping boys for anyone concerned with human and environmental degradation. But they are also historically very profitable.

The chart below compares the domestic benchmark Standard and Poor's Depository Receipts (NYSEArca:SPY) which tracks the S&P 500 Index with the most important major oil ETF, the Energy Select Sector SPDR (NYSEArca:XLE), and the tobacco company Reynolds American Inc. (NYSEArca:RAI).

The chart shows that while the benchmark SPY is negative over a ten-year period, both energy and tobacco provided good returns. The SPY has relatively limited exposure to tobacco and energy but these sectors are of course included in the performance of the SPY shown in the chart. Eliminating them from the SPY would make comparative performance weaker still. The chart understates the difference in performance and makes any potential decision to eliminate them more challenging.

SRI-focused ETFs take a variety of approaches to the challenge of investing in good without sacrificing financial performance. One approach is to maintain sector allocation but choose companies thought to have comparatively superior record of environmental, social and corporate governance relative to their peers in the same sector. iShares KLD Select Social Index (NYSEArca:KLD) falls into this category. It holds 200-300 companies chosen from the S&P 900 Index. The sector allocation is almost identical to the SPY benchmark though KLD holds no tobacco stock and a smaller allocation goes to utilities and energy companies when compared with the benchmark.

Similar to KLD but with stricter criteria is the iShares KLD 400 Social Index (NYSEArca:DSI). DSI is at once more selective and more pro-active compared with KLD. It automatically excludes investments the SINdex-- tobacco, alcohol and gambling. It also excludes companies involved in weaponry and nuclear power. DSI overweights companies with strong environmental corporate governance and human rights records.

Van Eck Market Vectors Environmental Services (NYSEArca:EVX) takes a different approach. It focuses on waste and selects companies that appear poised to benefit from more organized disposal and better practices. EVX's biggest holdings are Waste Management, which is mostly conventional nonhazardous disposal, Stericycle, which gets into regulated waste products from hospitals, blood banks, pharmaceuticals, and the French environmental services behemoth Veolia.

The 1-year chart below compares KLD, DSI and EVX to the benchmark SPY:

As the chart shows, these three funds are well correlated with the benchmark SPY. On the 1-year basis shown in the chart the two SRI funds KLD have a similar performance and are actually beating the SPY.

Another important approach to the challenge of building an SRI index is to offer exposure to the alternative "green" energy markets and emissions regulation. The 1-year chart below compares three green energy ETFs, PowerShares WilderHill Clean Energy (NYSEArca:PBW), Claymore/LGA Green ETF (NYSEArca:GRN), Van Eck Global Alternative Energy ETF (NYSEArca: GEX) with the SPY.

As the chart shows, these funds are not as well correlated with the SPY. They are very different funds.

PBW holds companies that aim to be cost-competitive with fossil fuels but in general are not yet competitive and therefore dependent on government subsidy. 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.

GRN, is an ETN (Exchange Traded Note). GRN tracks an index called the Global Carbon Index Return, which provide exposure to the price of carbon emissions. Though carbon emissions are of course global, most of the tradable carbon is covered by the European Union Emission Trading Scheme and Kyoto Protocol's Clean Development Mechanism. U.S. programs are currently less developed than European counterparts, but they do exist and may become more important.

GEX holds companies like Vestas Wind, First Solar, and the measurement company Itron. GEX focuses on large cap and foreign equity. Only 40% of the ETF is U.S. based. European countries compose about 50% and Asia 10%. This ETF has been hurt recently on dollar strength.

Within the alternative energy sector there are a number of sub-sector ETFs, like Claymore/MAC Global Solar Energy (NYSEArca:TAN), First Trust Global Wind Energy (NYSEArca:FAN). Most holdings are small cap stocks working on new approaches and new technologies. Typically these companies are dependent on government subsidy and favorable regulation. For investors who don't mind the volatility, an ETF would be a way to gain some exposure to these companies. These are not core holdings.

Probably the newest thing in SRI investing is the so called FaithShare ETF. The sponsor is FaithShares Inc. Their website features the slogan "invest with conviction." FaithShares sponsors five domination-based ETFs: FaithShares Baptist Values Fund (NYSEArca:FZB), FaithShares Catholic Values Fund (NYSEArca:FCV), FaithShares Christian Values Fund (NYSEArca:FOC), FaithShares Lutheran Values Fund(NYSEArca:FKL), and FaithShares Methodist Values Fund (NYSEArca:FMV). Despite expense ratios that are only slightly higher than some of the other SRI-focused ETFs, so far these funds have failed to win many converts. Their average daily trading volume is below 5000 shares.

The most important Socially Responsible ETFs as well as their expense ratios are listed below:

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%

Carbon Emissions

iPath Global Carbon (NYSEArca:GRN) 0.65%