October 15, 2006

The ‘Blue Mutual Funds’ Have Fundamental Problems

Filed under: Business Moves,Economy,Environment,Taxes & Government — Tom @ 3:08 pm

The idea behind the Blue Funds is that the stocks of companies that are managed in accordance with “principles of corporate social repsonsibility,” and that also give a majority of their campaign contributions to Democrats, will achieve better-than-average returns over time than companies in general, and especially compared to companies that aren’t “socially responsible,” give the majority of their campaign contributions to Republicans, or both. The “screens” used by the Blue Funds to determine companies that qualify as sufficiently responsible are here.

As you will see by the time I’m finished, the funds combine the principal potential disadvantage of a passively managed (or “index”) mutual fund, namely lack of flexibility, with the much-higher cost structure of an actively managed fund.

The two funds, a Large Cap Fund and a Small Cap Fund, are indeed modified forms of index funds, meaning that, at first blush, you might think that costs “should” be relatively low. BUT they will be anything but that, and the prospectus (PDF; includes both funds) indicates as much. Management fees for the two funds will be 1.5% and 1.75% of assets, respectively. Comparable fees for “pure” index funds the funds of the type The Blue Funds will be measuring themselves against are much lower. For example, Vanguard’s S&P 500 Fund has an expense ratio of 0.18% of assets; Vanguard’s Small Cap Index Fund’s expense ratio is 0.23% (it’s not measured against the Russell 2000, but the index it does benchmark is close enough).

Why the high fees? Because somebody (internal people, some external organization, or a combination of both) is going to have to be paid to monitor the “social responsibility” and giving patterns of 2,500 companies. That means keeping track of every single listed company in both the S&P 500 and the Russell 2000. To its credit, the Blue Fund is very clear about what this will entail:

Updated Frequently, Verified Independently

At The Blue Fund, we have established clear procedures for updating our information frequently:

  • Companies added to the S&P 500 are reviewed within a week and, if they pass both screens, are added to the portfolio
  • Companies added to the Russell 2000 are reviewed quarterly, if they pass both screens are added to the portfolio
  • Companies’ political donation data is updated every 6 months (June and December)
  • Companies’ social screen data is updated monthly

Our information is collected from the following independent sources:

  • Political giving data from opensecrets.org
  • Social research provided by KLD Research, a leading authority for social research in the investment space

(Note: One assumes that the continuous screening will be performed on every company in the entire S&P 500 [and the Russell 2000 in the case of the Small Cap Fund], so that “newly-deserving” Blue companies are identified on a timely basis. If non-qualifiers aren’t continually reviewed, there will be a serious hole in the procedures. — Ed.)

A pure index fund has no need for any of this. So it’s clear that The Blue Funds are taking on a lot more cost, and will need to assess the higher fees noted above. Those fees will, of course, reduce net returns.

But wait. It gets worse. The Blue Fund’s transaction costs will also be higher — probably much higher — than a “pure” index fund.

Let’s take The Vanguard 500 Index Fund. It invests in all 500 companies in the S&P 500 in proportion to their capitalization. The fund makes change in the stocks it owns only when a company gets kicked out of the S&P 500 and is replaced.

The Blue Fund will not be able to be as passive. Their Large Cap Fund will invest in only the smaller number of S&P 500 companies (The Blue Large Cap Index) that meet their “responsibility” and Democrat Party contributions tests. The Large Cap Fund’s managers have identified 76 such companies.

At the beginning, the managers will invest money in those 76 companies in proportion to their relative market capitalizations (as an index fund by definition must, and as the managers have said they will do). As the fund carries out its promises, some “responsible” companies will inevitably become “irresponsible,” or will fall below the 50% threshold in giving to Democrats (random thought: how do you handle a Lieberman situation?), and will have to be dropped.

Meanwhile, certain companies who are not Blue Large Cap Index members (and, note, probably not an equal number) will become “responsible,” and will have to be added. If they are already S&P 500 members, they’ll be added quarterly, while new S&P 500 members are added within a week. These requirements to stay true to fund objectives will generate a lot more turnover in the portfolio (buying and selling), and therefore will generate higher transaction costs, probably much higher, than a pure S&P 500 fund. There will not only be more straight substitution in the Blue Funds of the type that also occurs in any index fund; any time the total number of portfolio companies changes, a great many small transactions to reallocate funds among companies currently in the portfolio will also have to be carried out. For example if the portfolio expands to 80 companies after the first quarterly review, small amounts of the 76 original portfolio companies will have to be sold and reallocated to the four new ones. These small reallocations also have to be done any time one new qualifying company joins the S&P during a quarter. That’s a lot of buying and selling that looks like expensive busywork from here.

The average turnover in Vanguard’s S&P 500 fund, according to its prospectus, has been under 4% during the past five years. The Blue Funds’ turnover will have to be higher. And note that transaction costs are NOT included in the fees mentioned earlier — so the difference in the cost structures between “pure” and “blue” index funds is even greater than indicated.

And if you think the problem with the Blue Large Cap Fund is daunting, try applying it to what the Blue Small Cap Fund has to do, which is to select from and monitor each of the 2,000 companies in the Russell 2000. (Many of these companies are very small, get little publicity, and generally want to be left alone. Do you exclude them on that basis alone?) Since there are 467 Blue-approved companies in total 76 of them are in the S&P 500, that leaves 391 Russell 2000 companies. Yikes.

In sum, to open The Blue Funds to investors, the managers must, by definition, believe that their returns will be superior to their index fund benchmarks a margin that is big enough to make up for all of the higher fees and higher transaction costs (otherwise, they’re taking investors’ money under false pretenses, and the trouble they can get into for doing that is substantial). If that belief is not correct, investors interested in the best net returns (that’s the point, as even Blue Fund Managers acknowledge) who want to do index investing would be advised to stick with pure index funds.

Of course, the funds’ returns may not beat their benchmarks, and as the prospectus says in essence, that’s life. But if Blue Fund managers really don’t believe that returns net of the higher costs will be better, OR if they are true believers but really don’t have the research to support their claim, OR if the research is so full of holes it doesn’t matter what its conclusions are, they (read, very, closely) could be seen as breaching their fiduciary duty to their investors by taking their money, and could be very vulnerable to megabucks litigation if returns lag significantly.

And I believe there’s a problem with the research. The research supporting the “blue” premise for large caps is, in my opinion, very shaky, and the research for small caps appears not to exist.

As to large caps, this description from “The Blue Factor,” the study (PDF) that explains the rationale behind Blue investing, says the following (bold is mine):

The Blue Factor

When we looked at the performance of the 76 companies in the S&P 500 that met both sets of screens – in short, companies that both “give blue” and “act blue” – we determined that a market-capitalization weighted portfolio composed of all blue companies in the S&P 500 would have significantly outperformed the S&P 500 over a five-year time horizon.

Hmm. By looking five years back from June 30, 2006, the study totally missed almost all of the dot-com boom and dot-com/stock market bust that took place during the previous 5 years. I’m not in the mood to try to do full-blown research into that period, but I have to wonder how the premise would have held up during that time, and why it wasn’t reviewed.

The problem gets worse with the small caps, because the “Blue Factor” didn’t look at them at all, and the premise that blue small caps outpeform small caps in general seems to me intuitively shaky.

Especially with small caps, I will suggest that backward-looking research going back 10 years that starts with companies in business today, and then tries to compare the performance of blue vs. non-blue small caps, commits a tremendous oversight by ignoring the dot-com and high-tech companies, many if not most of whom were based in Metro San Francisco-San Jose or Metro Seattle, that went bust from 1998-2002. Guess what color most of those companies were? Hopefully, Blue Small Cap Fund investors will recognize that the superiority of “small-cap blues” has not tested, nor is it being asserted. I would have advised separate prospectuses to prevent any chance of confusion.

I would say that the Blue Funds have their “work” cut out for them, but here’s the ultimate rub — Thanks to the index investing approach, if it becomes obvious that “blue” companies are underperformers, there is nothing fund managers will be able to do about it without violating the promises they have made that they will passively invest. Because of this, if the premise behind the Blue Funds becomes demonstrably untenable, they will be forced to liquidate the funds. If they do not, they will be breaching their fundamental fidiciary duty, which is to maximize investors’ returns consistent with the level of risk being assumed.

Of course we don’t know, but it may be that the “Blue” in the funds’ names refers not to political philosophy, but how investors will feel after a few years of mediocre or poor investment results. I’m not going to sit here and assume that The Blue Funds are doomed to underperform the markets in general or non-blue companies (in fact, I find the claim that “blue” companies might be more innovative pretty credible), but I think it’s clear that there are plenty of reasons to be skeptical.

And if things don’t work out, it’s more than a little likely that some Blue Fund investors may experience a color change from depressed “blue” — to angry “red.”

The Latest Tibetan Outrage from Our Most Favored Nation ‘Trading Partner’

Filed under: Taxes & Government — Tom @ 11:40 am

China is doing in Tibet what it has always done in Tibet: killing Tibetans. But this time it’s videotaped in the YouTube era.

Read the story at Gateway Pundit, but DO NOT MISS the video at Students 4 A Free Tibet.

Maybe the Waltons and Bob Nardelli might want to have a peek. If you happen to know ‘em, show ‘em.

__________________________________________

UPDATE: Hot Air is on it.

Weekend Question 3: Why Can Madonna Crucify Christianity, But Positive Biblical Themes and Mockery of Other Religions Cannot Air?

Filed under: Business Moves,Taxes & Government,TWUQs — Tom @ 10:04 am

Don Wildmon makes some good points.

I am personally offended by Madonna’s latest crucifixion-mocking escapade, but would not want to prevent it from being performed in concert, or even aired. By the same token, if someone decides that they should withhold support from a network that airs it, or the program’s sponsors, it’s a free country. If enough people decide this, it hurts business.

Thus it should be noted that, according to an American Family Association e-mail, over 740,000 people have e-mailed NBC “asking NBC to show Christians the same respect they show other religions.” Apparently NBC is unmoved, which is of course their right.

But, as Wildmon has pointed out in that same e-mail:

Such was not the case when NBC refused to show Danish newspaper cartoons depicting Muhammad in a negative light. NBC’s message? Show respect for Muslims, but it is ok to bash Christians.

Given that its news division has forfeited the right to claim objectivity in its treatment of various religions, and the entertainment division’s outrageous watering down of Biblical references in “Veggie Tales” (scrubbing that the network will not be applying to Madonna), NBC should spare us excessive sanctimony about the “right to free expression” in the Madonna situation, and should recognize that there is economic risk they are voluntarily assuming in the hypocritical positions they are taking. The network should also note that the idea of threatening broadcast licenses, though brought up in different circumstances a month ago (and in my opinion, very improperly), is unfortunately in the arena of ideas these days.

Positivity: Cardinal’s Blog Outreach Getting Results

Filed under: Positivity — Tom @ 6:51 am

Boston Cardinal Sean O’Malley started a blog a few weeks ago, and will keep it going:

Cardinal O’Malley won’t stop blogging

Boston, Oct. 09, 2006 (CNA) – What started as an experiment for Cardinal Sean O’Malley has become a new and regular means of evangelical outreach. The cardinal-archbishop of Boston has decided to continue his blog, which he began on a recent trip to Rome.

Before his departure, the cardinal had committed to posting daily entries on his blog as a two-week experiment. He said he would consider whether he to continue it upon his return to Boston.

But the prelate has now announced that he would continue posting weekly entries on his blog, the first one hitting the web last Friday.

The site has not escaped the attention of the secular media. In an article almost two weeks ago, the Boston Globe noted that since he launched the website, the Franciscan-turned-prelate had received 9,000 visitors, 65,585 page views, and scores of comments.

Since that time the numbers have continued to grow.

Blog specialists have also taken notice, offering praise for a blog they say is informal and readable. In addition to his comments, the blog also features pictures of the cardinal around Rome and at different church ceremonies and posing in photos with friends.

In his first entry from Boston, the cardinal shared his week’s work and answered some questions from readers. One question was about Church art and architecture another asked his opinion on the best gelato in Rome. (The cardinal diplomatically sidestepped the question, saying it’s difficult to find a bad meal or gelato anywhere in Rome.)

Finally, the cardinal addressed a comment by a Boston native, named “Eddie”, living in Philadelphia, who said he was considering coming back to the faith due to the cardinal’s blog.

“Eddie, in your baptism, you were called to be part of a family, a community of faith, part of the Body of Christ,” the cardinal replied.

“Wherever your journey may have taken you up to this point, know that the Lord is always calling you home to be part of that community of faith, part of that family; that is the Church,” he continued.

“I would certainly encourage you to come home,” he wrote, adding that he would be happy to share the names of parishes and priests in Philadelphia that could help him to reconnect with the Church.

To access the blog, go to: http://www.cardinalseansblog.org/