For 'do-good' funds, an ethical dilemma

NEW YORK (Money Magazine) -- Uneasy rests the head that wears a halo, it seems. Consider the recent struggles of socially responsible mutual funds, which usually seek out companies with progressive labor practices and product lines that don't pollute or kill.

The typical "do good" portfolio has lagged the market of late, causing investors to yank out nearly $1 billion last year, or about 3 percent of the assets in ethical funds.

Why have so many socially responsible funds fallen behind the pack? For one thing, most of them missed out on the big energy rally of the past few years because they tend to avoid oil companies for environmental reasons.

That's in sharp contrast to the late 1990s, when the funds' social screening steered them clear of companies with legal and environmental liabilities and straight into tech stocks.

In fact, over the long run and before expenses, there is little difference in the returns of conventional actively managed and green funds, according to a study by finance professor Meir Statman of Santa Clara University.

Problem is, many ethical funds have higher than average expenses due to extra research costs and relatively small asset bases. High fees make it even harder for these funds to outperform their benchmark indexes.

Given all this headwind, it's not surprising that some green funds are overhauling their investing strategies and changing their social criteria.

The $1.6 billion Domini Social Index (Ticker: DSEFX (Charts), for example, has underperformed other index funds for the past few years thanks to its expense ratio of 0.95 percent, three times that of an average index fund. So the fund recently switched to an active stock-picking strategy.

"With our new strategy, I think we can improve performance," says founder Amy Domini - though the fund, now named Domini Social Equity, has hired managers, causing it to raise expenses to 1.15 percent.

Other funds are redefining their principles to give themselves more investment flexibility.

Pax World Balanced (PAXWX (Charts) decided to allow alcohol and gambling stocks after its rules required the fund to sell stakes in Starbucks (Charts), which licensed a coffee liqueur, and Yahoo (Charts), which presented directories of online gambling sites. "We want to focus on what companies are doing right," says Pax World CEO Joe Keefe.

Similarly, the Calvert fund group is reconsidering its prohibition on nuclear power since the technology may reduce greenhouse gases.

Critics contend that these moves amount to abandoning principles in pursuit of profit. And some green investors worry that by giving their managers more stock-picking latitude, socially responsible funds could end up owning more of the same stocks as regular funds.

Asks environmental activist Paul Hawken: "When does socially responsible investing become so broadly defined as to be meaningless?

And will the revamped strategies actually deliver better returns? Looser investment criteria may help, but higher expenses certainly won't. So if investing in a socially conscious manner matters to you, it's more important than ever to understand what your fund is up to and how to squeeze the most performance from it.

If a fund you're already holding is planning to change its strategy, SEC rules require it to notify you and send you an updated prospectus. But the feds don't mandate that an "ethical" fund adhere to any particular set of rules.

If you're considering a fund that calls itself socially conscious, recognize that you need to read beyond the label to know how the fund is investing.

It's hard to build a diversified portfolio with socially responsible funds alone. Most primarily hold large-cap stocks. As a compromise, suggests Morningstar analyst Bill Rocco, choose an ethical fund as your core holding and invest the rest in regular funds.

Not all green funds are expensive. Barclay's iShares KLD 400 Social Index (DSI (Charts), an exchange-traded fund, boasts a 0.5 percent expense ratio, and Vanguard FTSE Social Index (VFTSX (Charts) costs just 0.25 perecent.

With low-fee funds, there's a better chance you'll earn higher returns - and that means you'll have even more money to give to good causes.

___________________

4 stocks for an uncertain market

Retire Young: Build the sum you'll need

Money Makeover: Reach your goals with less risk