Responsible Investments An Analysis of Socially Responsible U.S. Mutual Funds

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1 Responsible Investments An Analysis of Socially Responsible U.S. Mutual Funds November 2008 introduction: This document examines the impact of Social Responsible Investing (SRI) in the U.S. mutual fund industry. SRI funds are designed to employ screening criteria that evaluate potential investments with respect to their corporate values and practices in addition to their potential future cash flows as investments. There are several distinct types of SRI funds. We attempt to dissect and evaluate each category of SRI funds independently. We then evaluate the performance and expense characteristics of the funds in relation to their industry peers that do not employ social screens in their investment selection process. SRI funds are not a new idea, but in recent years, we have seen an explosion in interest in them, specifically with respect to funds that seek environmentally responsible investments (green funds). We have chosen to display the majority of the data in the report since June 30, 2001, because there were very few green funds on the market prior to that date. Executive summary: SRI funds have been gaining a substantial amount of assets over the past few years, becoming one of the highest growth areas of the mutual fund industry. These funds still represent a very small piece of total industry assets, however. Major fund complexes that are not known for SRI funds have begun to develop and launch funds with socially responsible investment strategies. These complexes include DWS Scudder, PIMCO, and others. Expenses for SRI funds are, on average, higher than typical funds in similar Lipper classifications. A typical expense premium for an SRI fund might be basis points higher than for a non-sri fund. The investment returns of SRI funds have outperformed the returns of other funds over the past several time periods (six-month, one-year, and three-year periods). In past years, however, the returns of SRI funds have lagged the returns of their peers within their Lipper classifications. Contact Information: For immediate assistance, feel free to contact Lipper Client Services toll-free at or via at LipperClientServices@lipper.reuters.com. For more information about Lipper, please visit our website at

2 Table 1 Largest SRI Complexes Assets in SRI Funds ($Mil) Number of SRI Funds* Fund Complex Guidestone Capital Management $7, Calvert Asset Management Company $4, Ariel Investments $2,381 3 PIMCO $2,263 4 Pax World Management Corporation $1, Parnassus Investments $1,748 7 Saturna Capital Corporation $1,146 2 One Compass Advisors $1,025 2 Neuberger Berman Management $887 3 Domini Social Investments $ * Number of funds includes all share classes. Table 2 Largest SRI Funds Assets as of 10/31/2008 Fund Name ($Mil)* PIMCO:Tot Rtn III;Inst $2,151.1 Pax World Balanced;Inv $1,716.4 Parnassus:Eqty Inc;Inv $1,424.3 Ariel:Fund $1,296.4 GuideStone:Money Mkt;GS4 $1,123.9 GuideStone:Intl Eqty;GS6 $1,072.9 Ariel:Appreciation $1,054.5 GuideStone:Gro Eqty;GS6 $1,050.9 GuideStone:Val Eqty;GS6 $1,043.4 Calvert Lg Cap Gro;I $924.2 *Assets include the assets of all of the portfolio s share classes. SRI Fund Categories For the purposes of this research, we have divided the funds that Lipper considers SRI funds into four distinct categories. To determine the appropriate category for an SRI fund, we began by examining a copy of the most current prospectus for each fund to identify the specific criteria that the fund uses in its investment selection process. There is a substantial amount of overlap between the criteria for some of the categories as funds in one category may have some (if not most) of the same investment selection criteria as the funds in another category. For example, both the Calvert and GuideStone complexes avoid investing in companies that are engaged in the alcohol, tobacco, or gambling industries. However, Guidestone takes an ethical stance against investing in companies with ties to abortion, while Calvert avoids investing in companies with what Calvert views as negative labor or environmental records. In these cases, we used our best judgment in the determination as to which category a fund should be assigned. These funds employ SRI principles to exclude investments that have negative social impacts such as companies that are involved in the manufacture of alcohol, tobacco products, firearms, etc. They may also extend their criteria to include an examination of labor practices, environmental records, and other corporate practices considered to be responsible by the fund company. This category includes some of the most well-known SRI complexes such as Calvert, Domini, and Pax World Management. 146 funds are categorized as general SRI funds. Religious Criteria Funds These funds often have investment criteria similar to the general social criteria funds, but the standards exist for religious beliefs and morality reasons rather than for general social well-being. The funds are often marketed towards specific religious groups. Funds that employ specific investment criteria for Catholics, Muslims, and other religious groups fall into this category. Some of the fund complexes that fall into this category are GuideStone, MMA Praxis, and Timothy Plan. There are 90 religious criteria funds included in our analysis. These funds specifically target investments that have a positive environmental impact such as alternative energy and companies engaged in environmentally sustainable business practices. Some of the green funds that are included in the study are not designated by Lipper as SRI funds because of their relatively narrow investment focus many focus their investments within a particular economic sector (e.g. energy) rather than a diversified basket of SRI securities. Some funds that we designate as green funds exist within a larger fund complex that is not solely green focused (DWS Scudder and Fidelity). Others belong to smaller niche fund shops with only one or two funds. Note that some funds that are part of a larger SRI complex that might otherwise be considered green funds are included in the general SRI funds group because they are subject to a wider range of investment selection criteria than green investing alone, e.g. the Calvert Global Alternative Energy Fund is treated as a general SRI fund. In addition to its alternative energy investment strategy it is subject to the same investment rules as the other funds in the Calvert fund complex. We have identified 20 green funds for inclusion in our analysis. Tobacco-Only Funds There are a small group of funds (8) that Lipper categorizes as SRI funds because they employ criteria to filter solely for companies that are not engaged in the manufacture of tobacco products. These funds were not considered in the study because their criteria are much less research-intensive than the criteria of most other social criteria funds. Lipper Fiduciary Research

3 Asset Classes Figure 1 SRI Fund Asset Class Distribution While SRI funds reside in nearly all asset classes, the majority are concentrated within the United States Diversified Equity (USDE) Lipper classifications. Large-cap equity and multi-cap equity are the two largest groupings of SRI funds within the USDE asset class. Collectively, these two groups account for nearly 40% of all SRI funds on the market. The total net assets of SRI funds as of October 31, 2008 were $26.9 billion, representing less than ½ of 1% of total open-end fund industry assets. However, the assets in SRI funds have been growing substantially over the past few years. Other, 8% Balanced/Mixed- Equity, 6% World Equity, 12% Fixed Income, 14% USDE, 60% Multi-Cap,23% Large-Cap,16% Small-Cap, 10% Mid-Cap, 8% Other, 3% Growth in Assets Figure 2 Asset Growth Since September 30, 2001 (%) The growth in these funds (Figures 2, 3, 4, and 5) has been substantial over the past few years. Since 2001, general SRI funds have increased in assets by 71% and religious criteria funds have increased by 25%. Green funds, however, have increased in total net assets by a phenomenal 640% from $153 million to $1.1 billion (Table 3). Industry assets during the same time period increased by 82% on average, indicating that asset growth in general SRI and religious criteria funds have slightly lagged the overall industry growth rate. Green fund asset growth, however, outperformed the industry by a multiple of 7.8, creating one of the hottest growth areas in the mutual fund industry (Target Date/Lifecycle fund assets grew by an even larger 1,470% during the same time period). Total Net Asset Growth 1200% 1000% 800% 600% 400% 200% 0% -200% Sep-01 Mar-02 Religious Funds As of June 30, 2001, green funds held a meager $153 million in total net assets. By mid-2008, however, assets had grown to over $1.8 billion before dropping to their current level of $1.1 billion over recent months (Figure 2). While the rate of growth has been very high, it is important to note that green funds currently represent only 5% of the total assets in all social criteria funds, and much less than a tenth of 1% of total fund industry assets. table 3 Asset Growth Since September 30, 2001 (%) % Growth 10/31/2008 Assets 640% $1.1 Bil All Open-end Mutual Funds 82% $9.5 Tril General Social Funds 71% $14.8 Bil Religious Funds 25% $10.9 Bil Lipper Fiduciary Research

4 Figure 3 SRI Fund Asset Growth 45,000 40,000 All SRI Funds 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Figure 4 SRI Fund Asset Growth by Category 25,000 20,000 Religious Funds 15,000 10,000 5,000 0 Sep-01 Mar-02 Total Net Assets ($Mil) Figure 5 Green Fund Asset Growth 2,000 1,800 1,600 1,400 1,200 1, Sep-01 Jan-02 May-02 Jan-03 May-03 Jan-04 May-04 Jan-05 May-05 Jan-06 May-06 Jan-07 May-07 Jan-08 May-08 Sep-01 Mar-02 Total Net Assets ($Mil) Total Net Assets ($Mil) Lipper Fiduciary Research

5 Estimated Net Flows Figure 6 displays the estimated net flows for each of the three social criteria fund categories on a rolling one-year basis quarterly since One of the most remarkable points that the figure makes is that general SRI funds had exhibited very positive net flows until mid-2006 when the flows turned sharply negative by over $1 billion on an annual basis for several consecutive quarters. Much of this effect was driven by two of the largest funds in the category suffering very large outflows during this time period. After excluding these two funds, flows would have remained positive for the category during the period. Category outflows from this category of funds have been curbed somewhat since then, but the trend has yet to reverse itself entirely as flows have not yet turned positive. Since then, however, assets in the category have remained somewhat constant, indicating that the negative flows have been largely offset by asset growth generated by the performance of the category. Figure 6 Rolling One-Year Net Flows ($Mil) 3,500 3,000 2,500 2,000 1,500 1, ,000-1,500 Estimated Net Flows Religious Funds The estimated annual flows into religious funds have been positive since 2001, albeit barely (total annual net flows for the period are estimated at only $129 million). If the most recent rolling period from October 31, 2007, through October 31, 2008, were excluded, the category would have had negative total estimated net sales over the time period. Annual net flows into religious funds never varied by more than +/- 7% during the time period making flows into the religious funds category the least volatile (Table 4). Estimated net flows into green funds, however, have been in stark contrast to the up and down movements of general social funds and religious funds. Only a single data point in the rolling set indicated net outflow. All other periods indicated that net flows were positive for the category (Figure 7). Until fairly recently, the flows into green funds appeared to be increasing. The year ended June 30, 2008, was the strongest period for the green funds category on a dollar basis. When measuring the flows as a percentage of total net assets, the effect of net flows in the category is even more visible. In both the one-year periods ended March 31, 2006, and June 30, 2006, the assets of the green funds category more than doubled due solely to inflows into the funds. Flows into these funds have been very volatile. The standard deviation of annual flows has been greater than 30% since 2001 (Table 4). Figure 7 Rolling One-Year Net Sales as a % of Total Net Assets 160% 140% 120% 100% 80% 60% 40% 20% 0% -20% Table 4 Estimated Net Flows as a Percentage of Category Total Net Assets Average Annual Net Flows Standard Deviation of Net Flows 8.8% 10.6% Religious Criteria Funds 0.0% 2.9% 34.6% 31.8% Religious Funds Estimated Net Flows as a Percentage of Category Total Net Assets Data used for Figure 6, Figure 7, and Table 4 represents rolling annual net flows each quarter since June 30, All net flows data has been estimated. Lipper Fiduciary Research

6 SRI Fund Expense Ratios SRI investment strategies are not costless to employ, however, and these additional costs are reflected in the total expense ratios of these funds. As expenses tend to vary widely between asset classes, we believe that expenses within an asset class will be more relevant. variance in Figure 8. For this reason, simple averages may be heavily influenced by the presence of very small funds, while asset-weighted averages are dominated by the largest funds. Figure 8 illustrates the total expense premiums that SRI funds charge, relative to other funds in the asset class for the five asset classes with the greatest number of SRI funds. The five asset classes shown in the chart represent roughly 2/3 of all SRI funds and roughly 3/4 of SRI assets. Other asset classes may not contain enough funds to draw meaningful expense conclusions. For an example of how to interpret the data in the chart: A large-cap SRI fund, on average, has a total expense ratio that is 27.2 basis points higher (on an asset-weighted basis) than a non-sri large-cap fund. On a simple average basis, however, a large-cap SRI fund costs only 13.4 basis points higher. The asset-weighted average total expense ratio for an international diversified equity funds is 0.971%, while for international diversified equity funds that employ social investment criteria, the asset-weighted average total expense ratio is 1.265%. Asset-weighted total expenses for the five asset classes listed below average 25% higher than their asset class averages. The largest variance between the average and asset-weighted average in the expense premium chart occurs in the mid-cap equity asset class. The measures shown for this asset class represent 17 funds in the mid-cap group. Five of these funds, however, have back-end load or level-load structures and total expense ratios that are greater than 2%. However, the assets of these five funds comprise less than 1% of the total assets in mid-cap SRI funds, thus an asset-weighted average removes the influence of these very small funds, creating the wide It should be noted that these values tend to be driven by very large funds, while SRI funds tend to be smaller than the average fund. This means that the funds will likely not benefit from potential economies of scale that many funds in the asset classes likely would benefit from. On an asset-weighted average basis, religious funds have the lowest total expense ratios of the three SRI fund categories we examined, while green funds have the highest total expense ratios (Figure 9). It should be noted that the green funds category does not include any fixed income funds, while the general SRI funds and religious funds categories do include them. Eleven percent of the funds in the general SRI funds category and 27% of the funds in the religious funds category are fixed income funds. Fixed income funds, on average, tend to have lower expense ratios than equity funds, effectively driving down the overall expense ratios for these categories. After excluding all fixed income products the asset-weighted average total expense ratios for general SRI funds and religious funds would both be 107 basis points. Figure 8 SRI Fund Total Expense Premiums TER Premium Above Asset Class (%) Asset-Weighted Average Premium Simple Average Premium Figure 8 at left displays the total expense premiums that SRI funds charge, on average, relative to other funds in the same asset class. The burgundy bar reflects the asset-weighted average premium, whereas the gray bar represents the simple average premium. For example, a large-cap SRI fund costs 27.2 basis points more than a typical large-cap domestic equity fund, on average. Large-Cap Domestic Multi-Cap Domestic Equity Funds Equity Funds Mid-Cap Domestic Equity Funds Small-Cap Domestic Equity Funds Diversified International Equity Funds Lipper Fiduciary Research

7 It would not be entirely fair to make the blanket statement that green funds have higher expense ratios than other types of SRI funds, as these funds are typically much newer than some of the funds in the other SRI categories. Many of these funds have not yet had the opportunity to reach any potential economies of scale given their limited operating history. It is likely, that as the existing green funds establish a greater asset base, their expenses could decline to a level that is more comparable to the other two groups of SRI funds. SRI Fund Performance Figure 9 Asset-Weighted Average Total Expense Ratios (%) Total Expense Ratios by SRI Fund Category Interestingly, we note that in recent time periods, SRI funds have outperformed their Lipper classifications, on average. We examined the performance of all Lipper fund classifications that contain at least four distinct SRI funds. Classifications that contain less than four SRI funds were excluded to ensure that there are a sufficient number of funds in the classification to establish a central tendency for comparison purposes. We then compared the average total return performance of the SRI funds in the classification to the average performance of all funds in the classification to calculate the excess returns of the SRI funds relative to their respective classifications. Finally, we averaged the excess returns to determine whether SRI funds, on average, either over- or under-performed during the period. In the six-month period ended October 31, 2008, SRI funds outperformed their classification averages by 7 bps, on average. SRI funds also outperformed their classification averages in the one-year and three-year periods ended the same date; however, in the five-, and ten-year periods we begin to see a slight underperformance of SRI funds relative to their Lipper classification averages. SRI Fund Excess Returns (%) Figure Religious Funds Excess Returns of SRI Funds 0.07 Six M o n th s 0.40 On e Ye ar 0.02 T h r e e Ye ar s Five Ye ar s Excess Returns for periods longer than one year reflect annualized values T e n Ye ar s Lipper Fiduciary Research

8 Table 5 SRI Fund Holdings Top 20 Most Widely Held Equities Among SRI Funds 1 Goldman Sachs 2 Cisco Systems 3 Bank of America 4 Intel 5 Johnson & Johnson 6 Freddie Mac 7 Microsoft 8 Morgan Stanley 9 American Express 10 Hewlett-Packard 11 JPMorgan Chase & Co 12 AT&T 13 Citigroup 14 XTO Energy 15 Pepsico 16 Procter & Gamble 17 Emerson Electric 18 Fannie Mae 19 Time Warner 20 International Business Machines Table 6 All USDE Fund Holdings Top 20 Most Widely Held Equities Among All United States Diversified Equity Funds 1 Microsoft 2 Cisco Systems 3 General Electric 4 JPMorgan Chase & Co 5 AT&T 6 Intel 7 Exxon Mobil 8 Johnson & Johnson 9 Hewlett-Packard 10 Procter & Gamble 11 Bank of America 12 Apple 13 International Business Machines 14 Google 15 Chevron 16 Pfizer 17 Citigroup 18 American International Group 19 Goldman Sachs Group 20 Merck & Co Tables 5 and 6 at the left display the 20 most widely held equity securities among SRI funds and all USDE funds, respectively. Gray shading indicates that a security appears on both of the lists. All holdings data is as of the most recently available in the Lipper database (typically June 30, 2008). The securities are ranked by the number of distinct funds that hold the security. SRI Fund Holdings Tables 5 and 6 display the top 20 most widely held equities among SRI funds, and all United States diversified equity funds, respectively. While there is a significant degree of overlap between the two lists, there are some securities that are noticeably absent from the SRI list. Neither of the major oil companies on the overall most widely held list is included the list of top 20 most widely held securities (Exxon Mobil and Chevron). However, a much smaller oil company (XTO Energy) is among the most widely held equities by SRI funds. The two pharmaceuticals companies (Merck and Pfizer) are also absent from the SRI fund list. The SRI fund list also includes a greater number of financial sector companies, including a total of eight companies, half of which do not appear on the list for all USDE funds. Please note that holdings data reflects the most current data available in the Lipper database. Due to SEC reporting requirements most funds have not released holdings data that is more current than as of June 30, Conclusion There are many factors for an investor when choosing a fund. Recently, more and more assets have been flowing into socially responsible funds, however, investors should familiarize themselves with these types of investments prior to investing in the funds. We have found that SRI funds tend to have higher than average total expense ratios than their peers. These higher expenses create taller hurdles that must be cleared in terms of the returns that will be required in order to match the total returns of the funds peers. We also see that, at least in recent periods, these aforementioned hurdles have been overcome. The returns of SRI funds have been outperforming the returns of peers in recent time periods. It is unknown whether this trend will continue into the future. Authored by: Jonathan Kreider Fiduciary Research Analyst Fiduciary Services, Lipper Thomson Reuters All Rights Reserved. This report is for informational purposes only, and does not constitute investment advice or an offer to sell or the solicitation of an offer to buy any security of any entity in any jurisdiction. No guarantee is made that the information in this report is accurate or complete and no warranties are made with regard to the results to be obtained from its use. In addition, Lipper will not be liable for any loss or damage resulting from information obtained from Lipper or any of its affiliates. Lipper Fiduciary Research