Morningstar defines a socially conscious fund as any fund that invests according to non-economic guidelines. These funds will typically avoid companies involved in the defense industry plus companies involved in promoting alcohol, tobacco, or gambling.
Socially conscious fund managers may make investments based on issues including environmental responsibility, human rights, or religious views. Such offerings may take a proactive stance by selectively investing in environmentally friendly companies, or firms with good employee relations.
This weekly fund screen looks for the best opportunities within this growing, specialized category of equity funds.
Screening Process
The first thing I did was ask for funds designated by Morningstar as socially conscious. The screener produced 104 results, so the entire group is not that big, but growing. Thirty of these funds are new and not yet rated by Morningstar, leaving 70 to consider.
Next, I said give me only funds with Morningstar overall ratings of 4-stars or 5-stars, to limit the search to funds that rank in the top one-third of Morningstar's domestic stock fund universe. That brought the number of screen results down to 25.
From there, funds that impose front-end or deferred load charges were screened out, as were funds with high operating expenses of over 1.50%. Funds requiring minimum initial investments of over $10,000 were also screened out.
Lastly, funds with high relative risk (those scoring above 1.25 per Morningstar with 1.00 for the average stock fund) were also eliminated. This brought the number of screen results to ten.
From there, I compared the ten funds' management approaches and investment styles, historical returns and risk scores, operating expenses, and other qualitative factors. In addition to ratings and rankings by Morningstar, I looked at risk statistics such as Sharpe Ratio, beta and alpha in determining which funds we think offer the best overall opportunities in this specialized class.
Finally, I decided on two funds to show you - Pax World Balanced (PAXWX) and Parnassus Equity Income (PRBLX). I settled on these two because of their strong risk-return profile. Both funds are conservative relative to all stock funds, yet have posted results that are competitive.
Before I go into detail about the Pax World and Parnassus Equity Income funds, let me say that Ariel offers two competitive funds, Ariel (ARGFX) and Ariel Appreciation (CAAPX), which are socially responsible. However, I opted not to profile them today because they favor small company stocks, which can be more volatile than funds investing primarily in large company stocks.
Pax World Balanced PAXWX
Prior to Aug-7-2000, this fund was known as the Pax World Fund, America's original socially responsible fund launched in 1971. It normally invests around 60% of assets in equities, with the balance in bonds and money market securities. Accordingly, the fund is categorized as a 'domestic hybrid' fund by Morningstar.
In selecting securities, co-managers Chris Brown and Robert Colin look for stocks of companies that can produce goods and services that improve the quality of life. On the other hand, companies involved in manufacturing defense or weapons-related products as well as those engaged in liquor, tobacco, and gambling industries are excluded from the portfolio.
Since these two took over the portfolio management role in April 1998, the fund has delivered strong risk-adjusted performance on both an absolute and relative basis. Through Jun-4-01, the fund sports a 3-year average annual return of 11.8%, 5.5% higher than the return of the S&P 500 index and ranking in the top 5% of the domestic hybrid category, per Morningstar.
Morningstar attributes the managers' strong relative performance to smart sector bets and good security selection. In 1998/1999, the managers favored growth-oriented equities and let the fund's equity stake to grow to 70%. In 2000, they reduced exposures to tech, telecom and foreign stocks, and boosted exposure to health care and natural gas. These smart moves allowed the fund to put up a 5.7% gain in the year 2000, outperforming the S&P 500 index by 14.8%.
Relative to all stock funds over the trailing three years, this fund has produced returns that are roughly one-third higher than the average stock fund with less than half the relative risk.
The portfolio is invested mainly in giant, large, and mid-sized companies, for a median market cap of $18 billion. Its average P/E ratio is slightly higher than the S&P 500 index, while the fund's average earnings growth rate exceeds the S&P 500's also. This gives the fund's equity stake a large-cap growth bent, but in the past it has been included in the large-cap blend group. Accordingly, you can say that this fund maintains a slight bias to growth.
Because the fund holds bonds to balance portfolio exposure to equities, it has a low beta of 0.46. That means if the S&P 500 index goes down 10%, the fund drops just 4.6%, and vica versa. It may not keep up with all-stock funds during bull markets but it'll help you navigate through volatile markets and will better protect you in declining markets.
The fund's alpha of 5.53 indicates that the fund's co-managers have delivered returns that exceeded expectations (based on the fund's low beta).
Adding to the fund's appeal are its relatively low expenses and low turnover. At 0.89%, its annual expense ratio is well below the average stock fund (1.42%) and average hybrid fund (1.33%), per Morningstar. The fund's low turnover ratio of 21% makes it fairly tax-efficient, and suitable for taxable as well as tax-deferred accounts.
If you are looking for a conservative 'partial-equity' fund that is broadly diversified and incorporates social screens, you need look no further. It's one of the few socially conscious hybrids around, and arguably the best.
Parnassus Equity Income PRBLX
This fund is the younger, more conservative sibling of Parnassus Fund (PARNX), one of only seven socially conscious funds to beat the return of the S&P 500 index over the trailing 10-year period through Mar-31-01. Both funds are managed by Jerome Dodson, the president of Parnassus and the funds' original portfolio manager (17 years running Parnassus and 9 years running Parnassus Equity Income).
Parnassus Equity Income seeks both current income and long-term capital growth by investing primarily in a diversified portfolio of equity securities that pay above-average dividends and offer the potential for capital appreciation. Dodson says he follows a contrarian investment strategy that looks at both social as well as financial factors.
In stock selection, Dodson looks for companies that are paying a dividend at least equal to average stock in the S&P 500 which do not produce alcohol, tobacco, weapons or nuclear energy. Indeed, the fund's trailing 12-month yield of 1.8% is more than twice the average stock fund's 0.8% yield, adding to the fund's appeal.
Parnassus funds also include a unique social screen that permits the advisor to invest up to 10% of fund assets in community loan funds (that finance economic development and low-income housing).
While the fund has always had below average relative risk, fund performance has improved dramatically in recent years as 'value' sectors return to favor. Through Jun-4-01, the fund boasts a 3-year average annual return of 14.4%, 8% higher than the S&P 500 index and ranking in the top 4% of the large-cap value category, per Morningstar.
Relative to all stock funds over the trailing three years, this fund has generated returns that are roughly 80% higher than the average stock fund with 40% less relative risk, using data from Morningstar. That, my friends, is not too shabby for any fund.
Being a contrarian sometimes means buying technology stocks when they're more attractively (cheaply) priced. This gives the fund a little higher growth bent than its value peers, but overall it is still value-oriented. If the previously discussed fund lands somewhere between a blend/growth style, this one lands somewhere between a value/blend style overall.
Just as it remains true to value but includes technology, Dodson keeps the portfolio invested mainly in dividend paying large-caps but adds octane through its exposure to mid/small-cap securities, which make up more than a third of portfolio assets currently per Morningstar. Overall, the fund has a median market cap of $29.9 billion.
Like Pax World Balanced, this fund has a relatively low beta of 0.77 and a high positive alpha of 7.30. Accordingly, this fund won't go up as much as the S&P 500 index in rising markets, but will lose less in declining markets. For its risk level, Dodson does a good job of delivering excess returns, meaning he exceeds the returns that you'd expect to get given its low relative beta.
At 0.97%, the fund's annual operating expenses are considerably below average compared to the average stock fund (1.42%), adding to its appeal. With a trailing 12-month yield of 1.84%, you get a fund that essentially pays for its annual expenses, and still provides a yield that matches the average stock fund.
If you are looking for a conservative equity fund that's broadly diversified, emphasizes dividend paying companies and screens out social sins, the Parnassus Equity Income may be suitable for you. Investors willing to assume greater risk may wish to consider the fund's sibling, Parnassus Fund, also managed by Jerome Dodson.
Summary
In addition to being less volatile, both Pax World Balanced and Parnassus Equity Income do an excellent job of limiting downside risk, as evidenced by their relatively strong bear decile ranks.
These funds aren't going to keep pace with the high flyers during raging bull markets but they will finish the race for you and let you sleep at night. Both funds have relatively high yields that can add value over time by unleashing the power of compounding.
If you want to stick to large established companies, these funds may be right for you. If you prefer the added risk and potential return of mid/small-cap stocks, consider the two Ariel funds that I mentioned earlier. They're great socially conscious funds too.
Performance Charts
Pax World Balanced (PAXWX)
Parnass Equity Income (PRBLX)
