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Mutual Funds

What You Need to Know About Ethical Investing

Doing good with your investments -- and earning a good return, too -- can be a tricky proposition.

1. "Ethical" is in the eye of the fund sponsor. The typical socially screened mutual fund avoids companies that profit from gambling, pornography, tobacco, alcohol or weapons. Some funds also award special consideration to companies that have, say, strong environmental or workplace-diversity standards.

2. Welcome to the back of the pack. There are nearly 200 distinct mutual funds and exchange-traded funds that say they adhere to ethical-investing standards. But for all the diversity of choice, the one thing these funds have in common is their propensity to underperform: Over the past ten years (as of February 15), 56% of socially screened funds trailed their peer group's average (that is, they returned less than the average of funds that invest in similar styles). Over the past year, 63% lagged.

3. Look for holes in the screens. You may cringe at some businesses that still make the cut. Monsanto, which manufactures pesticides and genetically modified seeds, has become the target of public fury for tactics that strong-arm owners of small farms. But Monsanto is among the holdings of iShares FTSE KLD Select Social Index (symbol KLD). And if you are opposed to abortion, you might not feel comfortable owning shares of Teva Pharmaceutical, which manufactures the morning-after (or "Plan B") pill. Yet Teva is a top holding of Pax World Balanced (PAXWX), one of the oldest socially screened funds in existence.

4. Do it the Buffett way. Take a wild guess who holds the honor of being the world's top philanthropist. (Hint: In order to give away large sums of money, you have to start with inordinate sums of money.) But Warren Buffett doesn't give a hoot about any moral gray areas of the businesses he invests in -- unless they affect the value of those investments. If your ultimate goal is to make a difference, take a page from Buffett's playbook: Evaluate potential investments solely on their merits as investments. Then when you're ready, donate a portion of your gains to charities that cater to the issues you care most about. To make your donated dollars go further, look for charities that score high on Charity Navigator's ratings for financial efficiency ( Charitynavigator.org)

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5. The best of the bunch. A few socially screened funds are standouts. Parnassus Equity Income ( PRBLX) has generated a solid record while avoiding companies that deal in alcohol, tobacco, weapons, gambling and nuclear power. We have long been fans of Amana Trust Growth (AMAGX) and Amana Trust Income (AMANX), two funds with outstanding records that invest according to Islamic principles and so avoid alcohol, pornography, gambling and banking. Environmentalists may like Portfolio 21 (PORTX), which invests globally. And the still-young Appleseed Fund (APPLX) is one of a few funds that take a deep-value approach to socially screened investing, trolling for companies that sell for bargain prices.

6. No more Mister Nice Guy. Does all this talk about do-gooding make you feel like pouring yourself a tall one? Then the Vice Fund (VICEX), which invests in bombs, booze, gambling and smokes, may be just right for you.