Surprising Holdings In The “Socially Responsible” ETF

by on May 24, 2010 | ETFs Mentioned:

Socially responsible investing is by no means a new concept; mutual funds that limit holdings deemed to companies deemed to be good corporate citizens have been around for nearly 40 years. Socially responsible or “sustainable” investing has been slow to make its way into the ETF industry, but there are signs of that changing; last week ESG Shares launched its North America Sustainability Index ETF (NASI). Meanwhile, two funds from iShares, the FTSE KLD Select Social Index Fund (KLD) and FTSE KLD 400 Social Index Fund (DSI), now have more than $200 million in aggregate assets.

Look Under The Hood

There are some misconceptions about socially responsible investing. This investment strategy generally consists of identifying stocks deemed to have positive environmental, social, and governance (“ESG”) factors. In addition to the moral aspect, there may be some nice perks to this selective process; there is a fair amount of evidence suggesting that stocks with higher ESG scores tend to outperform the broad markets over the long term. Such a trend would make sense logically–favorable public perception and avoidance of legal troubles generally translate into lower risk.

Some investors are under the impression that socially responsible indexes consist of wind farms and organic food manufacturers. In reality, these benchmarks consist of well-known companies that operate in almost every corner of the economy. KLD’s top holdings include Microsoft, Procter & Gamble, and IBM–large, multinational firms deemed to possess positive ESG characteristics.

There are some inherent challenges to socially responsible investing within the ETF wrapper. Because most ETFs are by nature passive, the process for determining eligible companies must be standardized and prohibit manager discretion. KLD, for example, is linked to an index that consists of large cap companies that are determined to have positive environmental, social, and governance performance relative to their industry and sector peers and in relation to the broader market, while at the same time maintaining risk and return characteristics similar to the FTSE U.S. 500 Index. According to the fund’s prospectus, the index provider “evaluates each eligible company’s ESG performance using standardized criteria and assigns an ‘overall rating’ to each company.”

KLD has just over 250 individual holdings (see a breakdown of KLD holdings). While many of these holdings are recognized as good corporate citizens, there are some surprising components as well. As of April 20, holdings in KLD included:

Transocean Ltd. (RIG)

The world’s largest offshore drilling contractor, Transocean is now best known as the owner of the oil rig that exploded last month and caused a massive oil leak in the Gulf of Mexico. The U.S. government has identified BP as the responsible party in the accident, and BP has accepted responsibility for the cleanup costs. But at a Congressional hearing, the chairman of BP America indicated that Transocean was conducting the well drilling operations. Noting that “only seven of the 126 onboard the Deepwater Horizon rig were BP employees,” McKay clearly looked to direct some of the blame to Transocean.

Now it looks as if BP is stepping up its efforts to shift blame to Transocean. According to the Wall Street Journal, two BP executives claim that “Transocean’s own documents specify that its workers aboard the Deepwater Horizon rig were in charge of operations and monitoring the oil well.”

Transocean recently drew criticisms for approving a $1 billion dividend to shareholders as cleanup efforts continue. At a closed door meeting in Switzerland (where Transocean relocated for tax purposes), Steven Newman declined to answer questions from reporters regarding the efforts to cap the leak in the Gulf of Mexico.

Halliburton (HAL)

Halliburton has found itself at the center of a few controversies over the years, and was also involved with the Deepwater Horizon rig that exploded and sank last month. The oil services giant was responsible for cement work on the Deepwater rig, and Halliburton workers were involved in sealing the well through a combination of cement, pipes, and plugs (see a timeline of events that led to the leak).

It seems that Halliburton had largely carried out BP’s orders on the oil rig and may be able to distance itself from the disaster. But the firm has still come under attack from the White House and seen another ding to its reputation.

Goldman Sachs (GS)

Goldman’s shares have plunged in the weeks since the SEC filed a suit against the Wall Street behemoth in the U.S. District Court. The charges against Goldman stem from the bank’s role in selling a collateralized debt obligation called Abacus 2007-AC1. Goldman didn’t disclose that Paulson & Co., a hedge fund firm that was betting on the instrument’s decline, was responsible for helping to select some of the underlying mortgage securities.

Even before the fraud charges, the financial sector was struggling to restore its public image as banks reported record profits and impressive trading streaks as job losses continued to mount. The allegations against Goldman have added fuel to the “Wall Street vs. Main Street” fire, painting the bank as a symbol of corporate greed that profited from the collapse of the MBS market (see Why Reform Bill Boosted XLF).

Disclosure: No positions at time of writing.