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October 16, 2002
Screening the Gambling Sector from High Yield Investments Can Be Tricky
    by William Baue

Screening out gaming sector investments from high yield portfolios presents challenges, including identifying private gaming companies and controlling tracking errors.

Many socially responsible investors screen companies involved in gambling from their investment portfolios. This strategy is relatively easy to implement in equity investment, as the gambling industry constitutes only a very small segment of the equity universe. However, companies involved in gambling make up a large portion of the high yield universe, which makes it more difficult to screen these companies out of high yield portfolios. High yield investments are also referred to as "junk bonds" because they are often purchased for speculative purposes. High yield investments involve non-investment-grade bonds that generally carry credit ratings below BB. The risk inherent in such investments is associated with the possibility of high yields.

Only one high yield product exists in the retail socially responsible investing (SRI) market, the Pax World High Yield Fund (ticker: PAXHX). Institutional investors, on the other hand, have more opportunities to employ SRI strategies toward the high yield sections of their portfolios. For example, the Evangelical Lutheran Church in America (ELCA) Board of Pensions practices socially responsible investing and includes high yield investments in its portfolios. Among the other SRI strategies the ELCA uses, it screens gambling from its high yield portfolio.

"[W]e screen all asset classes that contain corporate exposure for gambling and other harmful products in our 'Social Purpose Fund' series," said Mark Haney, senior investment manager with the Internal Fixed Income Group of the ELCA Board of Pensions. "The ELCA, the Board of Pensions, and the Board's social criteria consultant collaborate in developing the screens and proprietary screening tools using a public equity data base. Industry codes identify companies that generate any revenues from gaming, which are then added to our 'Social Criteria List,' prohibiting our managers from new investment."

Many investments attempt to track a benchmark, often an index. For example, a portfolio may attempt to invest in all of the companies the Credit Suisse First Boston (CSFB) High Yield Developed Countries Only Index invests in. However, if a portfolio screens out companies engaged in gambling and the index does not screen for gambling, the portfolio is unable to track that index as closely. Screening, therefore, can introduce tracking errors. As of August 30, 2002, the gaming sector composed 9.8 percent of CSFB High Yield Developed Countries Only Index. Clearly, screening out almost a tenth of this investment universe complicates efforts to track the index.

"The most difficult challenge is controlling, or even quantifying, the tracking error resulting from screening out an entire industry," Mr. Haney told "[A]nother challenge is simply identifying the players. Many small gaming companies are private and do not show up on our public company database."

These private companies can borrow on the public bond market, and hence are available for high yield investment. Identifying these companies and screening them out of high yield portfolios represents an additional research step for social investors.

Interestingly, the gaming sector has performed particularly well over the past year.

"The gaming sector has held up extremely well as gamblers tend to keep gambling through recessions," said Pax World High Yield Fund Portfolio Manager Diane Keefe. Pax World Funds' social investment policy has screened out companies that own or operate casinos since Pax World Funds was founded in 1971. "The exclusion of gambling companies has hurt performance this year and in years past."

However, screening gambling has not debilitated the Pax World High Yield Fund. It ranks in the top 27 percent of all high yield funds monitored by Lipper Analytical Services for the year-to-date ended September 30, 2002.

Although avoiding a whole sector can affect a portfolio, most high yield managers agree that factors specific to the bond issuer drive performance, according to Mr. Haney.

"Over long time horizons, we don't believe that eliminating this industry group will have a meaningful impact on performance of high yield bonds," said Mr. Haney.

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