(FORTUNE Magazine) – People who once refused to soil their portfolios with General Electric, a known collaborator with the Defense Department, are now crowding into mutual funds that are not contaminated with GE, Exxon, and other disreputables. But socially conscious investing (a phrase that suggests buying shares in Who's Who) is one of those ideas that's silly at first blush and ridiculous on closer inspection.

Capital allocated by Bleeding Heart instead of Invisible Hand ends up in places where the owners can feel good about it, not where it can make the most of itself. In the Soviet Union, money allocated on the basis of a moral master plan resulted in a glut of steel mills and a shortage of grocery stores. Here, if all the money were ethically invested, we'd have a glut of Celestial Seasonings tea and Ben & Jerry's ice cream (or maybe not--read on!), but there'd be no gas for the cars and no lights in half the houses after the nuclear power plants shut down for lack of funds.

The latest estimates from the fans of this sort of scenario are that $639 billion has been ethically invested--so what does that mean, the other trillions of invested dollars come from scum?

And where does all this ethical investing leave the individual? Let's say you are an ethical investor. After you cleanse your portfolio of all Philip Morris stock, should you now give up your bowl of Post Raisin Bran, since Post is a division of Kraft, which is part of Philip Morris?

As part of an overall campaign, ethical investing helped rid South Africa of apartheid. But pursued as a scattershot strategy, it has minimal impact on world affairs except to provide employment for the professional portfolio cleanser.

The fact that holdings of a mutual fund are the legal property of the fund itself, with no way to connect any particular shareholder to any particular investment, has not dampened the appeal of these moral laundering services. At present count there are 42 known ethical funds in various stages of evolution. The earliest go back more than 50 years and were started by fuddy-duddies who didn't want liquor, gambling, or tobacco in their portfolios. Then the cause was taken up by the no-nukes crowd, the Greenpeace crowd, the NOW crowd, and others. There are at least two ethical index funds, a politically correct version of the S&P 500. There's a woman's fund, considered to be highly ethical even though it promotes gender discrimination (imagine the outcry if somebody started a WASP fund).

The managers of these ethical funds have their hands full rating companies on their emissions, their hiring policies, gender policies, gay policies, health care policies, the CEO's salary, and whether they test products on rats. Most of the obvious ne'er-do-wells (Exxon, Union Carbide, etc.) were banished from ethical portfolios long ago. Beyond that, the business gets quite murky. Coca-Cola, for instance, shows up as ethical in one fund but not in another (it must have something to do with the cola nuts).

Lately there's been a curious turn of events, in which top-rated ethical companies are being downgraded. The Body Shop has been accused of lax morals on a variety of fronts, beginning with the "oil spill" when 30 gallons of Orange Spice shampoo were dumped into the Hanover, New Jersey, sewage system. From the later hoopla this caused, you would have thought the Exxon Valdez had done the dirty deed. In 1994 an expose of the Body Shop appeared in an ethical investing magazine. Partly in anticipation of the article, the stock dropped 15%.

Ethical investors have been sold on the notion that by not investing in evil companies like Exxon and Union Carbide, they can avoid losing money in Exxon Valdez-type disasters. But the Body Shop affair has shown the danger in owning a stock that's widely held by ethical institutions. Investors can lose money in an ethical selloff the first time this highly moral company gets its halo examined.

Even Ben & Jerry's was a recent target of a hot probe: To wit, only 5% of the nuts in its Rainforest Crunch ice cream were purchased from the people in the rain forest. The company promptly underwent a "moral audit," which in the world of ethical mutual funds is what passes for a confession.

As tawdry as it might be to consider such a thing, the return on investment from ethical mutual funds has been mediocre. There are certain notable exceptions, but overall the group "does not do that well," according to Jon Teall at Lipper Analytical. Over the past 12 months, the 39 ethical funds tracked by Lipper have returned 18.2%, vs. 27.2% for the S&P 500. "When you start really limiting yourself like they do, you're going to have problems," he says. If fund managers have to check for rats in the labs or call the rain forest to get the latest figures on the nut trade, when do they have time to study the balance sheet and the income statement?

REPORTER ASSOCIATE Ed Brown