On Dec. 14, 2012, when Gerry Sullivan learned that a deranged killer had gunned down 26 people at Sandy Hook Elementary School in Connecticut, he looked into positioning his mutual fund in Smith & Wesson stock.
Shares of the gunmaker would plunge in the wake of the massacre, he reasoned. Then they'd slowly rebound as Congress ignored calls for stricter gun controls.
Using a Bloomberg terminal at his office in Summit, N.J., Sullivan watched the stock plunge from $9.54 on Dec. 13 to $7.74 on Dec. 18. That's when he pounced, initiating a position in Smith & Wesson in the $316.9 million Vice Fund (VICEX) he has managed since 2011.
At press time, Smith & Wesson shares were selling at nearly $14.
Cold-blooded? Unfeeling? Exploitive? In a way, that's Sullivan's stock in trade. The Vice Fund is one of the few remaining "sin" funds that advertise their investment in alcohol, tobacco, gaming and defense stocks. Proponents are generally indifferent to social issues, reasoning that any profitable company deserves a place in a good investment portfolio.
So-called sin funds, or what's left of them, occupy the opposite end of the spectrum from "socially responsible investing" funds, whose proponents emphasize investments that tend to benefit society. Sullivan mostly scoffs at what he sees as the flawed motivation of such do-gooders. "I couldn't say no to the Smith & Wesson trade," he says. "I think you should align your investing philosophy in a way that preserves your capital and gives you income and appreciation over time. My only bias is: Does the stock fit in my portfolio, and can I put myself in a trade where I understand the risk?"
The Four-legged Vice Stool
The Vice Fund's top four holdings are all tobacco companies: Lorillard, Philip Morris, Altria Group and Reynolds American, respectively. (Lorillard and Reynolds announced July 11 that they were in merger talks.) Raytheon and Lockheed Martin also make Sullivan's top 10 as aerospace firms that work on drones. Casino operators MGM Resorts, Las Vegas Sands and Wynn Resorts are there, as is Brown-Forman, which owns liquor brands Jack Daniel's, Southern Comfort, Woodford Reserve, Herradura, el Jimador and Finlandia.
Tobacco, weapons, gambling, liquor--Sullivan considers these the "four-legged stool" of his fund. "It doesn't sound like a great investing strategy, but the four sectors work so well together," he says.
Sullivan shies away from the few public porn companies. "I don't see a depth of offerings in that area," he says. "Besides, we have enough trouble with what we have. Porn might be the kiss of death." He is also dismissive of marijuana stocks, sold mostly on the OTC market. He sees long-term promise, but since cannabis use is still against federal law, he doesn't believe it's a wise investment now.
Sullivan's end-of-the-fiscal-year letter to shareholders on May 31 underscored how his four chosen "sins" complement each other. During its fiscal year, the Vice Fund was up 22.12 percent, while the S&P 500 finished up 21.86 percent. Alcohol and tobacco underperformed, as did British gaming company Ladbrokes (the fund's worst performer, down 36 percent), but Macau-based hotel and casino operator Galaxy Entertainment was up 108 percent, more than offsetting the declines.
As of mid-June, tobacco was up 15 percent, alcohol was up 5.5 percent and defense was up 4.25 percent, according to Sullivan, while gaming was down 9 percent. "Because of my extended position in Lorillard, I'm up for the year," he says.
Performance hasn't been a problem for the Vice Fund. Morningstar has given it five stars--its highest rating--for the past 10 years. "The Vice Fund has great performance numbers," says David Kathman, a senior fund analyst for the Chicago-based investment research firm. "But the name probably turns some people off."
Bland is Good
That's been a problem with vice funds since they first appeared in the late 1980s. Take the mutual fund Morgan SinShares, which changed its name to Morgan FunShares in 1989 so as not to frighten off investors. It was liquidated in 2003.
It's one thing to manage a vice fund that caters to contrarian individual investors, but the holy grail for mutual-fund managers is to tap into the $19.4 trillion U.S. retirement market, which includes annuities, individual retirement accounts (IRAs) and employee-sponsored 401(k)s.
In their 2007 report "The Price of Sin: The Effects of Social Norms on Markets," Harrison Hong of Princeton University and Marcin Kacperczyk of the University of British Columbia state: "There is clearly a societal norm against funding operations that promote human vice, and consequently many investors may not want themselves or others to support these companies by investing in their stocks."
Indeed, huge institutional investors with billions to spend--such as pension funds, universities, banks or insurance companies--aren't keen on adding holdings that feature the names "vice" or "sin," since their operations are transparent and open to public scrutiny.
That's why, in his May 31 letter to shareholders, Sullivan announced a name change, from Vice Fund to Barrier Fund. He figures the Vice Fund could grow to $500 million, but with a tamer name it could be a $1 billion-plus fund once it starts showing up as an option in retirement accounts. "We needed to soften the name of the fund," Sullivan says. "The real place to be is on a 401(k) plan, on a recommended list. That's where the real assets are. But you don't get on those lists with a campy, novelty name.
"Frankly, there are people out there who would invest in the S&P 500 in the blink of an eye without realizing how much of it was in tobacco or defense," he adds. "But we can't see Merrill Lynch adding us to a selected list with 'vice' in the name."
Virtue Investing Takes Off
On the opposite end of the spectrum is socially responsible investment (SRI). Observers seeking its origins cite the university-led pullback of investment in South Africa during the 1980s, when the country lived under apartheid rule. Fueled by student protest, endowment funds shed their stock in companies doing business with South Africa. Partly as a result of international pressure from investors, apartheid rule ended in 1994.
A turning point for SRI came in 2005, according to Julie Gorte, senior vice president of sustainable investing at Portsmouth, N.H.-based Pax World Management. The company's Balanced Fund manages about $2 billion in assets. "We began to link the severity of Hurricanes Katrina and Rita with climate change," she says. "Wal-Mart was hurt--no one could get to its stores. Half of the S&P 100 reported material losses. For Wall Street, climate change became real. Sustainable investing has become more mainstream since I joined Pax in 1999."
Just last year, an angry Rahm Emanuel instructed fund managers of Chicago's pension reserves to find out how much of their holdings were invested with assault weapons manufacturers. The mayor said he hoped to initiate a national campaign of disinvestment, similar to the one that helped topple apartheid.
Calvert Steps Up
Bethesda, Md.-based Calvert Investments is credited with forming the first socially responsible mutual fund in 1987. The Calvert Equity Portfolio (CSIEX) is now a $2.9 billion fund, while Calvert's suite of SRI funds boasts $13.2 billion in assets under management. Calvert not only screens out vice stocks from its portfolios; it uses 13 sustainability analysts to find public companies that rank highly in areas of environmental performance, social responsibility and corporate governance. "At Calvert, we spend most of our time looking at how companies are preparing to succeed in an environment of climate change and future global poverty," says Stu Dalheim, vice president for shareholder advocacy.
Adds senior vice president and national sales manager Anthony Eames: "We take a 21st-century view on sustainable investing. We look at what strong companies are doing to minimize their effect on environment--no fines, lawsuits over cleanup of spills--and who take care of their employees and recognize them as human resource. These are the companies that are going to lead the way from an innovation standpoint."
Top-10 holdings in the CSIEX fund include Apple, CVS Caremark, Wells Fargo, Costco, Coca-Cola and Qualcomm.
Some SRI funds decline investment in Apple, citing labor problems that surfaced at Chinese plants where the company's products are manufactured. The TIAA-CREF Social Choice Equity Fund (TICRX) excludes Apple from the 825-plus stocks it holds. But Eames says Calvert's due diligence shows that Apple has made progress in its overseas labor policies; the company is now Calvert's largest single holding, across all its funds. Additionally, Calvert has "seen a lot of leadership from Coke" in the areas of labor, bottling and water usage, Eames says.
"Not everyone may like all our choices," he points out. "But we've done a lot of engagement with both companies, and while they may have a long way to go, we recognize progress."
He adds, "Every company in our portfolios has met rigorous sustainability criteria and financial analysis."
Calvert also holds stakes in McDonald's, Dow Chemical and Marathon Oil, citing their progress in meeting sustainability goals.
Employees Take the Lead
Socially responsible investing has thrived as more U.S. employers switch from corporate pension plans to defined contribution plans that require employees to choose where their money is invested--usually in mutual funds. Eighty percent of U.S. employees in defined contribution plans such as 401(k)s would like a sustainability option, but only 25 percent have them, Eames says, adding that one-third of Calvert's billions in assets are in retirement plans.
A broader range of people began to invest in mutual funds as retirement plans shifted to employee contributions, Morningstar's Kathman concurs.
"Anecdotally, that seems to be a factor in the growth [of SRI funds]," he says. Morningstar tracks more than 100 mutual funds in the SRI arena.
There are thousands of asset owners and asset managers who consider SRI issues when investing, according to Lisa Woll, CEO of US SIF: The Forum for Sustainable and Responsible Investment. "There is more product, more research, more analysis, more publications talking about it," she says, citing mutual-fund managers like Calvert, Pax and Parnassus Investments that "for 25 years have believed you can make significant progress in returns while not investing in companies that engage in poor practices."
The acronym SRI, she adds, has in many circles been replaced by ESG (environmental, social and governance). "Conventional investors are beginning to understand that if they do not consider, address and manage ESG or sustainability factors, then they assume unnecessary risk," Woll says.
'Double diligence' at PaxPax manages $3.4 billion across its 11 funds, with $2 billion in its flagship World Balanced Fund, according to a spokesperson.
Pax makes its investment choices using a process called "double diligence," according to Gorte. Four of Pax's 50 employees conduct sustainability analysis of companies, she says. "We look at how they manage environmental risk, how they treat their work force, how they manage relationships in the communities where they are located. We look at the governance factor; not just the board of directors but their policies on corruption."
This research transpires alongside a traditional financial analysis. "We all live on the same floor," she says. "Yes, we disagree, but there is a ton of respect."
The index funds are rebalanced quarterly; the actively managed funds are constantly being tuned by the portfolio managers. "If a company no longer meets our criteria, it doesn't belong in the portfolio," Gorte explains.
Mead Johnson, for instance, "kept having problems" with its infant formula and was pulled from Pax funds, she says, adding, "A week later Wal-Mart pulled the product from its shelves."
Newell Rubbermaid and Goldman Sachs are among companies that were recently added to Pax Funds. The Pax World Balanced Fund's (PAXWX) top 10 includes Google, Apple, Morgan Stanley, BlackRock, DirecTV and UnitedHealth Group. "We're always looking for well-managed companies to invest in," Gorte says. "Not only for financial performance, but also from an ESG perspective. We believe they'll perform better in the long run."
While Calvert and Pax actively manage the stocks in their funds, a number of SRI funds simply track the MSCI KLD 400 Social Index, which since 1990 has ranked companies with high ESG ratings, while excluding those involved in alcohol, tobacco, gambling, civilian firearms, military weapons, nuclear power, adult entertainment and genetically modified organisms.
Alternative- and renewable-energy companies are still too young and unstable to attract wide interest from some of the larger SRI funds, though investors can choose from Firsthand Alternative Energy (ALTEX), Fidelity Select Environment and Alternative Energy (FSLEX), Guinness Atkinson Alternative Energy (GAAEX) and a smattering of exchange-traded funds, including PowerShares WilderHill Clean Energy (PBW).
"Solar and wind portfolios have been terrible," says Vice Fund's Sullivan. Even Calvert's Eames deems it "a volatile sector." Gorte at Pax, who says renewable energy has "not been fun at all," sees signs of rebound. "In the last year, solar has been a delightful place to be," she says.
Other specialized funds attract activist investors of several stripes. The $52.9 million Pax Ellevate Global Women's Index Fund (PXWEX) tailors its investments to companies that promote gender equality. Its top holdings include 3M, American Express and Roche. The $556 million Parnassus Endeavor Fund (formerly known as the Parnassus Workplace Fund), invests in companies that provide a positive workplace for employees; its top holdings include IBM, Target and Wells Fargo.
To Screen or Not to Screen
Some analysts scorn any type of investment screening, whether to weed out or select vice or virtue stocks. As Morningstar's Kathman explains, modern portfolio theory suggests that if investors restrict their investment universe in any way, they restrict the universe from which they can draw, which can result in lower returns. But after studying SRI returns for years, he concludes, "It's a 'free good' that doesn't cost anything in terms of returns."
That doesn't mean individual funds don't underperform, Kathman adds, "but there's no good evidence that SRI funds as a group do any better or worse than other funds over the long term."
Conversely, with respect to screening out vice stocks, Hong and Kacperczyk conclude in their paper "The Price of Sin": "Some investors, particularly institutions subject to public scrutiny and social norms, pay a financial price for not holding these stocks."
Financially, sin stocks may offer good returns, and funds that invest in them may boast top ratings. But politically, at least in the mutual-fund universe, virtue has all but vanquished vice.
Top 10 Holdings
VICE FUND (VICEX)$316.91 million under management
|% of assets||YTD returns %|
|Philip Morris (PM)||6.09||-1.19|
|Altria Group (MO)||5.83||11.46|
|Reynolds American (RAI)||4.93||23.30|
|MGM Resorts (MGM)||4.31||13.10|
|Las Vegas Sands (LVS)||3.61||-0.11|
|Wynn Resorts (WYNN)||3.59||9.49|
|Lockheed Martin (LMT)||3.41||9.85|
CALVERT EQUITY A (CSIEX)$2.92 billion under management
|% of assets||YTD returns %|
|CVS Caremark (CVS)||4.30||7.01|
|Gilead Sciences (GILD)||3.92||13.57|
|Wells Fargo (WFC)||2.86||17.56|
|Costco Wholesale (COST)||2.79||-2.45|
|Intercontinental Exchange (ICE)||2.73||-16.58|
|Danaher Corp. (DHR)||2.63||3.24|
PAX WORLD BALANCED INDIVIDUAL FUND (PAXWX)$2 billion under management
|% of assets||YTD returns %|
|Becton, Dickinson and Company (BDX)||2.61||9.39|
|U.S. Treasury Note 0.25%||2.08||17.82|
|Morgan Stanley (MS)||1.84||23.52|
|U.S. Treasury Note 0.375%||1.78||9.62|
|UnitedHealth Group (UNH)||1.64||N/A|
As of July 15, 2014 | Source: Yahoo Finance