Social-equity fund raises questions about indexing

Your Funds

June 04, 2006|By CHARLES JAFFE | CHARLES JAFFE,MARKETWATCH

Amy Domini likes stirring things up. As head of the company running the world's largest social investment fund, she has taken on corporate giants trying to improve the way they do business and make them better citizens.

Recently, however, Domini stirred up her own fund, in a move that not only raises questions for shareholders in Domini Social Equity, but which highlights bigger philosophical questions facing investors in many index funds.

Domini notified regulators that her fund (ticker DSEFX) plans to change the way it is managed, leaving behind the trademark Domini Social Index and turning to an active management strategy.

The move requires shareholder approval, and observers wonder whether investors will want to give it; others wonder if this kind of style shift is a sign of things to come for index funds.

The $1.2 billion Domini Social Equity fund is the oldest and largest fund screening prospective investments for social and environmental reasons. The fund tries to deliver the gains of the Domini 400 Social Index -- which is made up mostly of large-cap stocks -- in the hope that investors can do good and do well at the same time.

The fund is just barely above average over the past decade, but it has been a bit of a lemon since 2000. For the last six full calendar years, the fund finished just once in the top half of its peer group, according to Morningstar Inc.; it had two years in the bottom 15 percent of its peers, which is also where it stands thus far in 2006.

That lagging performance pushed Domini to make a change.

"For the last six years, it has been difficult to get stellar performance using the index strategy," Domini said last month. She noted that industry weightings required by the index strategy made it difficult to add value, saying: "I have felt that the investor was better off in an active strategy for a while now."

Testing her theories, Domini Social Investments opened its European Equity Fund last fall. Domini's firm screens the universe of acceptable stocks, and then lets Boston's Wellington Management Co. use a quantitative approach to run the dollars.

(Quantitative investing uses computer models to make unemotional trading decisions; Wellington's plan for the Domini fund considers more than 60 factors, mostly concerning a stock's value and momentum.)

Domini's European fund has killed the benchmark index over its short history. Year-to-date, Morningstar shows that the new fund has beaten the MSCI EAFE Index by a full 10 percentage points.

That was enough to persuade Domini to make the big change.

If shareholders approve of the strategy shift, money management chores at the domestic fund will go to Wellington, so that Domini's flagship fund operates just like its new sister. Domini will maintain positions in stocks that management has started a dialogue with, as part of its push for social changes.

"There is no change in the agenda, just in the way the money is being run," Domini said.

But investors typically have an agenda, and they may not be up for the change.

Switching from a passive to an active strategy comes at a cost; the fund's expenses will rise to 1.15 percent from 0.95 percent. The fund's universe of potential investments is expanding, which could tilt it away from large-company stocks a bit.

Then there is the big issue, the fundamental difference between indexing and active management; supporters of index investing can be hard-nosed in their attitudes of how a fund should be managed.

"For a lot of people, indexing is a religion," says Stephen M. Savage, editor of the No-Load Fund Analyst newsletter. "Changing to a quantitative approach is not as stark as if they hired an active manager to pick stocks qualitatively using fundamental research, but it's still a step away from what most index investors are used to."

Here's where the story has broader implications. Indexing came into vogue decades ago, first because big institutional investors thought it was a good way to run money, and then because consumers wanted in. It appears that "quant investing" is going through a similar renaissance now, with a lot of smart institutional dollars going to managers who use this more flexible, less-static approach.

"Indexing diehards have been getting their heads handed to them for investing with blinders on, and so they are shifting their focus," says Dan Wiener, editor of The Independent Adviser for Vanguard Investors.

Ultimately, investors in the Domini fund must decide to accept the change or to go with other social funds that take an index approach.

jaffe@marketwatch.com

Charles Jaffe writes for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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