Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Wednesday, May 31, 2006

Domini Abandons Its Own Index Fund

Domini Social Investments, usually one of the biggest friends and beneficiaries of the SRI movement, has taken the unusual step of abandoning its own index fund, the one that tracks the Domini 400 Social Index (ticker: DSEFX) in favor of active management. The new fund has filed to hire Wellington Management as the fund manager. Since the company has been such a friend of the SRI community, I hate to do it, but I must speak my mind against this move.

The move speaks volumes about the greed pervasive in the mutual fund management business rather than the merits of either Domini, Wellington, or the Social 400 Index. You see, indexing is a low margin business for mutual fund managers. The grand-daddy of this model is Vanguard, whose flagship fund based on the S&P 500 charges a grand total of 5 basis points in expenses. That is $5 born by the shareholders for every $10,000 invested. The average actively managed mutual fund, by contrast, charges 1.57 percent, or $157 for every $10,000. What the Vanguard funds lack in high fees, they make up in volume. Their index funds are among the largest funds in the universe.

Make no mistake about it. On a macro-basis, index funds deliver superior returns relative to the actively managed set. Yes, a large number of actively managed funds deliver superior returns every year, but studies have shown again and again that the number of funds that do so consistently is frighteningly small.

The reason for the underperformance is simple -- expenses. If the market delivers historically 8 - 12 percent a year, 1.57 percent in expenses represents 13 - 20 percent of the expected return. That kind of leakage would make Las Vegas blush. In his great book "The Battle for the Soul of Capitalism", John Bogle cites a study where, over the last 25 years, mutual funds have returned on average a sum that is less than the overall market return by a number that is startlingly close to the amount that was drained in expenses. It may not sound like much, but over the working life of the average individual (43 years), that 13-20 percent leakage could mean that your portfolio at retirement is ONE THIRD what it would have been without it.

So, with it being clear that indexing delivers superior returns, the not-so-secret key to indexing well is to find the index funds with the lowest expenses. This insight has created a price war among index fund families. The management fees of the largest index funds has cratered over the last several years to where 5 basis points is now the standard.

Vanguard is the only big-name fund family that never took the "mutual" out of the mutual fund business. The company is itself owned by the fund shareholders, whereas virtually every other fund complex is owned by large financial conglomerates, so there is no pressure to pad expenses to benefit the management firms. Consequently, it is able to offer the best index funds. The Vanguard social index fund, based on the FTSE4Good index, has an expense ratio of 25 basis points, 5x higher than the S&P 500 fund, but still a good value. It does, after all, take considerable resources to add the social research and screening. The Domini fund capped their expenses at a borderline unconscionable 95 basis points for their index fund, over 3x what their Vanguard competitor charges.

The management at Domini would want to plead that this is because of the fund's size. I dispute this notion. Unlike actively managed funds, where the fund investors bear the expense of research, travel, management salaries, and customer support, the biggest expense at running an index fund should be the cost of shareowner communication -- sending the statements, prospectuses, confirmations, etc. Vanguard has more assets, but also more shareholders, and they are able to keep expenses down. The problem must be a lack of willpower to go the route of shareowner best interests. To them, it would be easier to capitalize on their name and get away with fund expenses that are many multiples of an index fund.

This is a shame. For those in non-taxable accounts, if you have the Domini fund, it is now time to switch fund families.

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