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May 26, 2006
Domini Fund to Shift from Indexing to Active Management
    by Bill Baue

Domini Social Investments proposes shifting the Domini Social Equity Fund from tracking the Domini 400 Social Index to being actively managed by Wellington Management.


What does it mean when the oldest socially responsible investing (SRI) index fund decides to drop the oldest SRI index in favor of active management? Yesterday, Domini Social Investments filed a proxy statement with the SEC seeking approval from Domini Social Equity Fund (ticker: DSEFX) shareowners to switch from tracking the Domini 400 Social Index (DSI) to being actively managed by Wellington Management. Since its 1991 inception, the fund has tracked the DSI, launched by KLD Research & Analytics the year before to test whether social screens impair (as was widely assumed at the time) or enhance financial performance.

The index has passed the "test" with flying colors.

"The Domini 400 has demonstrated that there is no inherent cost to social investing--that's a huge triumph," said Adam Kanzer of Domini. "It is still doing its job--outperforming the S&P 500."

The DSI has generated annualized returns of 12.03 percent since its inception, while the S&P 500 has returned 11.31 percent annually over the same period. However, both the DSI and the Domini fund have experienced a wavy ride over the past decade and a half.

"The fund has always been overweight in tech and telecom, so it kicked butt in the late '90s when tech was doing so well--it pummeled the S&P 500," said David Kathman, an analyst with mutual fund rating agency Morningstar. "Then when the bear market hit and tech and telecom stocks tanked, this fund did relatively poorly compared to the S&P 500."

"For the last five years, the fund has faced severe headwinds, as the recovery has been driven largely by sectors where it is underweight--energy, industrials, and utilities," Mr. Kathman told SocialFunds.com. The fund has generated annualized returns of 1.66 percent over the five-year period ending April 30, according to data provided by Thompson Financial Network, while the S&P 500 has returned 2.70 percent annually during the same period. "If the fund had been actively managed, it still would have faced those same headwinds--changing to active management won't necessarily change the sector allocation drastically."

Of course sector allocation is only one factor in determining performance--the expense ratio is another factor, which can distinguish performance of the index from that of the fund significantly.

"While the index itself has outperformed, an index fund has expenses--and our expense ratio has always been high for an index fund, a consequence of the social screening, paying for the index, and the fact that we're a small firm," Mr. Kanzer told SocialFunds.com. "We've come to realize it is virtually impossible for a firm our size to effectively compete with other index funds when the likes of Vanguard and Fidelity are in a price war to reduce the expenses in their funds."

Vanguard's SRI index fund (VFTSX), which shifted from tracking the Calvert Social Index to the FTSE4Good US Select Index last year, has an expense ratio of 0.25 percent, while Domini caps the expense ratio for its index fund at 0.95 percent. For many large institutional investors, the difference of 70 basis points is much more significant than the name on the SRI benchmark.

The fund's expense ratio will climb to 1.15 percent--below the industry average of 1.34 percent for domestic equity large blend funds according to Morningstar. However, Domini expects Wellington's quantitative analysis and computer modeling based on valuation and momentum factors to more than compensate for this increase. According to Mr. Kathman, the shift from passive management will also free the fund to benefit from more individualized stock picking and weighting--a move that Domini sees amplifying the financial benefits of SRI screening.

"We're convinced that social and environmental screening adds value, but it has been frustrating to see this undermined by the market-cap-weighted structure of the portfolio," said Mr. Kanzer. "For example, we can't hold the three biggest energy companies because of the environmental screens, so we hold a lot of smaller companies, and their performance has been great, but you don't see it in the performance of the fund because they're too small."

"We think that the new strategy is going to enhance the strength of the use of social and environmental screens," Mr. Kanzer added.

While the shift means KLD would lose one of its lucrative index accounts, the firm also stands to gain, as the move would end the exclusivity clause that prevented KLD from licensing the DSI to any other public investment products. (KLD will continue to license the index to a number of private separately managed accounts.)

"This change by Domini Social Investments presents KLD with a number of new opportunities," said Tom Kuh, managing director of KLD's indexes. "We're talking to a number of people about the possibility of licensing it for mutual funds and exchange traded funds."

"We think the market is moving to indexes, as evidenced by the growth of assets in ETFs and indexed mutual funds, and we think indexing in the SRI space is also very vibrant these days," Mr. Kuh told SocialFunds.com. "Our expectation is that we will be able to find plenty of opportunities to license the Domini Social Index for other investment products."

 

 
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