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Socially Responsible Funds Finally Get Some Respect

Fed up with malfeasance? Try a fund that focuses on companies with good corporate governance.

As the mutual fund industry slaps a steak on its

new black eye from Eliot Spitzer, individual investors -- many feeling more betrayed than ever -- are looking for money managers who can spot trustworthy companies. The phrase "corporate governance" has never sounded so sexy.

Enter the realm of socially responsible investing. Long mocked for a feel-good approach to an industry that eschews feelings altogether, funds that focus on companies that adhere to certain social and environmental standards -- and increasingly, to good corporate governance -- are gaining respect among investors who are fed up with malfeasance.

"Assets in socially responsible funds have grown considerably," says Morningstar analyst Shannon Zimmerman. "There's definitely more investor interest in the wake of the recent corporate scandals." (

Click here for tips on choosing a fund that's right for you.)

Now, these funds are not a magic bullet -- indeed, for every study that says companies that adhere to the stricter standards of socially responsible funds outperform their peers, there's another that proves there's little to no difference.

And while the historic returns on socially responsible funds aren't lagging those of regular funds, they're not charging ahead, either. According to Morningstar, domestic equity funds are up 20.35% for the year and 4.75% over five years, as of Sept. 11. Socially responsible funds turned in slightly lower returns in the same period -- 18.02% for the year and 3.34% over five years. Still, socially responsible funds roundly beat the

S&P 500

, which returned just 15.5% returns year to date and lost 2.5% over the past five years.

Whether socially responsible funds keep pace with or even beat the overall market, though, isn't the point, adherents say.

"That's not the reason to be a socially responsible investor," says Amy Domini, founder of

Domini Social Investments

, one of the leading firms in the field. "You invest this way because it's the right thing to do ... just like you should pay more for products that are more costly because they were made by paid workers and not slave labor."

Similarly, while these funds have a lower-than-average expense ratio, they're still more costly than alternatives offered by the likes of

Vanguard

,

TheStreet Recommends

TIAA-CREF

and other top-notch fund families. But if the extra level of due diligence is worth it to you, there are several offerings by

Ariel

,

Calvert

,

Citizens

, Domini,

Parnassus

,

PAX World

and

Winslow

fund groups that will impose additional criteria above and beyond ordinary fiscal metrics.

Historically, individuals (and some funds) that focused on socially responsible investing relied primarily on "negative screens," which essentially ruled out companies that didn't pass muster for a specific (and blatantly obvious) reason, according to Doug Wheat, director of

socialfunds.com, an investor education organization. Few socially responsible funds, for instance, will invest in companies that manufacture tobacco products or weapons, or that use animals in testing their products, or have too few executives who aren't white men. All fairly noble screens, to be sure, but not terribly proactive.

Corporate Governance Gains Appeal

Socially responsible funds have long placed emphasis on investing in firms with good corporate governance practices -- and have been devoting even more resources in that area of late. "As an industry we're way ahead of the curve in emphasizing corporate governance," Domini says. "We've always looked at overpaid directors and chief executives, outrageous compensation plans." Such "positive screening" requires extensive research into a company's policies and practices, looking for positive contributions to society or the environment.

Still sound a little squishy to you? Well, these fund managers are hardly functioning as the Woodstock of the industry. Instead, their adherence to good corporate governance in

all

areas has allowed most of them to avoid the big flame-outs of

Enron

,

WorldCom

,

Tyco

(TYC)

,

Global Crossing

and the like.

"These other social, environmental and cultural issues are very revealing about where a company stands on all corporate governance issues," says Joe Keefe, senior adviser of strategic social policy for Calvert. "If you avoid them on these issues, you can dodge the blowups later."

Calvert flunked

Halliburton

(HAL) - Get Halliburton Company Report

and

ImClone

(IMCL)

for poor corporate governance and business practices, Tyco for environmental issues, and WorldCom for labor and workplace issues, to name a few.

'Roaches in the Drawer'

Environmental issues, while often overlooked (or even scoffed at) by more traditional portfolio managers, provide a good indication of how the executives and directors comport themselves on a variety of issues, according to Sophia Collier, president and chief executive of Citizens Funds.

"Environmental violations are a great indicator of a company in trouble," Collier says. "We avoided Enron not because we were prescient regarding their energy trading deals, but because they had egregious environmental violations. The company was not run with an eye toward community standards. It's the 'roaches in the drawer' theory."

Granted, good companies frequently run into problems -- in terms of environmental violations or elsewhere. But well-run companies will implement a system to make sure those violations don't recur.

Excessive compensation also can be a strong indicator of something awry with a company, Domini says. Her firm looks for companies that pay their chief executive less than $500,000 and pay outside directors less than $30,000. That's not as limiting as it sounds, Domini points out -- the bulk of companies in the Fortune 1000 meet that criteria -- and it's also not a drop-dead cutoff. The firm rarely invests in companies that pay their CEOs more than $10 million, or their outside directors more than $100,000. And all compensation packages are scrutinized, including stock option deals.

Given the recent scandals tainting the fund industry, investors also can take heart that these socially responsible firms practice what they preach. Since there are serious limitations as to how

individual investors can protect themselves from suspect funds, there's some heartening news here: You won't worry about Citizens or Calvert or Domini getting named in the next Spitzer suit. (Not that you need to worry about that with Vanguard, TIAA-CREF,

Fidelity

or a multitude of other fund firms, either.)

Calvert, for instance, keeps a close eye on market-timing -- an issue that

plays a key role in the current Spitzer mutual fund probe. The firm turns down an average of 10 to 12 suspect trades a day. It also implemented a redemption fee on accounts greater than $100,000. If an account is redeemed within 30 days of opening, there's a 2% redemption fee -- a costly way to abuse the system.

Citizens, meanwhile, closed 14 accounts in 2001 and 2002 opened by

Bank of America

(BAC) - Get Bank of America Corp Report

brokers -- the chief offender in the Spitzer suit -- because it spotted attempts at market-timing. "If a small mutual fund company in Portsmith, N.H., spotted 14 accounts," Collier says, "you know they were preying on a host of mutual funds. Punishment for that should be swift and certain."