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FEATURE ARTICLE - JAN/FEB 2006
Exchange Traded Funds
Enjoy the diversification of a mutual fund coupled with the trading flexibility of individual stock investments.
One of the fastest-growing trends in investing, the exchange traded fund (ETF), just got more socially responsible. With the launch of two different kinds of responsible ETFs last year, social investors can now join the many other investors who have helped ETFs grow from nothing at their debut 13 years ago to a universe of nearly 200 funds controlling around $250 billion in 2005.
With advantages over investing in individual stocks, like low fees, tax efficiency, and, in some cases, instant portfolio diversification, ETFs can be an important new part of a socially responsible investor’s portfolio.
ETFs are baskets of securities—or shares of corporate stock or mutual funds, corporate or government bonds, and various other investment instruments—that exhibit some qualities of an index mutual fund and some qualities of a stock.
To understand ETFs, you need to understand market indexes and index funds. An index, essentially, is a list of stocks assembled to track the performance of a particular market segment—companies from a particular country, for example, or specializing in a particular technology—or it can be diversified, including many different types of companies. The Domini 400 Social Index, for example, is a diversified index of 400 companies across a range of industries that are considered to be more socially responsible than their conventional counterparts in the S&P 500. An index like the NASDAQ biotechnology index, in contrast, tracks only companies in the biotechnology industry.
An index fund is a mutual fund made up of companies from a particular index. For example, the Calvert Social Index Fund seeks to match the performance of the Calvert Social Index™, a benchmark for measuring the performance of large- and mid-sized US-based socially responsible companies. ETFs resemble index funds in that they too are established to mirror the performance of an index of stocks.
However, unlike index fund investing, which requires buying or selling only at the closing price of each business day, ETF investing allows buying and selling throughout the day—much like investing in individual stocks.
Also like stock market investing, ETF investing is done through a broker, and can begin with the purchase of as little as one ETF share. All strategies associated with stock market trading can be used in the purchase and sale of ETFs as well.
ETFs tend to draw investors who are interested in these real-time trading features, or in ETFs’ management costs, which are typically lower than those of index mutual funds. Index mutual funds typically have lower rates than actively managed mutual funds, where fund managers make decisions about each stock in their portfolios, rather than following an index .
Socially Responsible ETFs
The two socially responsible ETFs launched in 2005 represent one of each type of index defined above—diversified and targeted.
ishares KLD Select Social Index Fund: Barclays Global Investors launched an ETF last January called the iShares KLD Select Social Index Fund, which mirrors the performance of the KLD Select Social Index. This diversified index of 250–350 large companies is screened and weighted to maximize social responsibility. While the KLD index is based on the same list of companies found on the conventional Russell 1000 Index, the KLD index excludes all tobacco companies and weights all other companies on the list according to each company’s social and environmental performance. For example, General Electric, the largest holding in the Russell 1000, drops to number ten in the KLD index because of its social score, meaning the KLD index includes fewer General Electric stocks. The iShares KLD Select Social Index Fund holds to socially responsible shareholder voting guidelines that support greater reporting on environmental, labor, diversity, product safety, and human rights issues at the companies included.
Powershares WilderHill Clean Energy fund: In March, PowerShares launched the PowerShares WilderHill Clean Energy Fund, which mirrors the performance of the WilderHill Clean Energy Index. This non-diversified index tracks 37 companies that invest in wind energy, solar energy, and hydrogen fuel cells. WilderHill’s ETF, the PowerShares WilderHill Clean Energy Fund, had a performance so
impressive last fall that it earned notice as an ETF to watch from a range of financially focused publications, from MarketWatch to the Wall Street Journal. In fact, MarketWatch reported last fall that PowerShares WilderHill ETF posted a 21 percent gain in the third quarter of 2005, in response to skyrocketing oil prices.
ETFs, Pros and Cons
In general, the advantages associated with ETFs are low fees, tax efficiency, ease of investment, and—when mirroring the performance of a diversified index—diversity.
1. Lower fees. Traditional mutual funds often come with a number of fees, which increases their expense ratios (or the percentage of your investment used to cover the funds’ expenses). By contrast, the primary expense associated with an ETF is a typical brokerage fee, which will vary depending on the broker, but can in some cases lower your expense ratio to as little as 0.1 percent.
2. Tax efficiency. Though index mutual funds themselves are highly tax efficient compared to actively managed mutual funds, they still can generate high tax bills through their capital gains—or the amount by which the current selling price exceeds your initial purchase price. By law, a mutual fund must distribute capital gains to shareholders annually—which are taxable. ETFs, by contrast, generally make no annual capital gains distributions and are therefore taxed minimally—usually only when the ETF is sold off permanently.
3. Ease of investment. Unlike investing in individual stocks, you don’t have to choose from the broad universe of stocks on the market. Instead, you select an index you like, which serves as the list of stocks you’ll use, and then start investing through your broker.
4. Diversification. By investing in an ETF drawn from a diversified index, you can—with as little as one share—instantly buy into a comprehensive and diversified portfolio across a range of investments. The main drawback to ETF investments can be the brokerage fee, which, as in stock market investing, is charged for each buy-and-sell transaction. If your broker’s fees are especially high, or if you anticipate making many small, daily transactions, these fees could start to add up. Check your broker’s fee structure before investing in an ETF.
The socially responsible ETFs from iShares (using the KLD index) and PowerShares (using the WilderHill index) offer competing pros and cons. Because the KLD index is diversified, its accompanying ETF offers less risk than the WilderHill ETF. It invests in a larger range of companies, using proxy voting rather than divestment to nudge less-responsible companies toward greater corporate responsibility. The WilderHill index, on the other hand, offers an index ideally suited for investors concerned about shifting toward renewable energy sources, but as an undiversified index, holds greater potential for wide swings in performance. In the Wall Street Journal article exploring WilderHill’s recent success, financial analyst Dan Culloton warned, “It’s dangerous to invest in funds that have recently spiked; they could do the same thing to you on the way down.” If you think an ETF might be right for you, be sure to consult a financial planner to discuss your risk tolerance and the specifics of your own financial situation.
Socially Responsible Indexes
If you’re not interested in the new ETFs, you may still want to take a look at the investment vehicles associated with various socially responsible indexes.
SRI indexes have been around since 1990, when Domini Social Investments introduced the Domini 400 Social Index (DSI). Domini builds the DSI by selecting approximately the top 250 socially responsible companies included on the Standard & Poor’s 500 Index, one of the most commonly used benchmarks for the overall US stock market. To those companies, Domini adds around 150 additional companies specifically chosen for the index.
In selecting companies for the index, Domini screens out companies that derive any revenue from alcohol, tobacco, and gambling products, as well as companies that derive two percent or more of their revenue from military weapons systems. Companies included in the index have been evaluated for criteria like commitment to environmental sustainability, diversity, and positive employee relations.
What’s more, recent data has shown socially responsible indexes to meet and even exceed their mainstream counterparts in profitability. For example, on the occasion of the index’s fifteenth anniversary, in May of 2005, Domini released figures showing that during its 15-year run, the companies on Domini’s index as a whole had outperformed the Standard & Poor’s 500.
In the years since the DSI launched, a number of other socially screened diversified indexes have been developed, including the Calvert Social Index, the Citizens 300 Index, and the KLD Large Cap Social Index. Other, more narrowly construed indexes focus on specific issues (often referenced, like the WilderHill Clean Energy Index, in their names). For example, the KLD Catholic Values 400 Index excludes companies with ties to alcohol, firearms, gambling, the military, nuclear power, tobacco, and abortion.
Remember that you cannot invest in an index itself, but rather in an index fund that tracks that index. For a list of socially responsible indexes that have an associated index fund, and for contact information on the socially responsible ETFs, see the box below.
Following is a list of socially responsible indexes associated with an index mutual fund. (The KLD Select Social Index and WilderHill Clean Energy Index are also associated with an exchange traded fund.)
• Calvert Social Indexes: 800/368-2748.
• Citizens 300 Index: 800/223-7010.
• Domini Social Index: 800/762-6814.
• KLD Indexes (Select Social, Global Climate 100, Catholic Values 400, etc.).
• Light Green Advisors Eco-Indexes: 206/547-8645.
• Mennonite Mutual Aid (MMA) Indexes: 800/348-7468.
• TIAA-CREF Social Choice: 800/842-2776.
• WilderHill Clean Energy Index