Ethical Investment Funds & the S.E.C.

It was sort of bound to happen eventually. An ethics-based investment fund has been nailed by the U.S. Securities and Exchange Commission for, you guessed it, an ethics violation.
Here’s the (very good) story from Ron Lieber at the NY Times: Socially Responsible, With Egg on Its Face

When the news broke late last month, it read almost like satire. The Securities and Exchange Commission had charged a mutual fund company that specialized in socially responsible investments with taking stakes in companies involved with alcohol, gambling and military contracting.
But it is a true story, and it’s the first time the S.E.C. has encountered this problem. Pax World, one of the oldest practitioners in the field of socially responsible investing, paid a $500,000 penalty.

Lieber’s analysis is great; I strongly recommend reading it. But I’ll add my own 2 cents’ worth….

At least 3 issues are worth talking about, here. First, there’s the one that on the surface makes this a “juicy” story,” namely the fact that it was (gasp!) a so-called “ethical fund” (or socially responsible investment fund) that the S.E.C. nailed, here.

Everyone loves to hate a hypocrite, and even the whiff of a shadow of the appearance of hypocrisy is enough to bring a smirk to the cynic’s lips. Hypocrisy is the right charge when someone promotes X but does not-X, or is at least (overly?) unreliable at doing X. So a politician who preaches “family values” but who has a string of torrid affairs is a hypocrite. But note that a charge of hypocrisy with regard to X requires agreement on what constitutes X. It’s much trickier to make a charge of hypocrisy stick if the nature of characteristic X is up for grabs or if its attribution to the person or group in question is open to debate.

In this regard, it’s worth noting briefly that “ethical” funds are self-designated as such. Calling yourself an “ethical fund” is no more automatically authentic than a charitable organization’s claim to speak on behalf of women, the poor, the whales, what have you. “Ethical funds” are not necessarily ethical funds. Certainly there’s the possibility of charlatanism, of funds claiming to filter investments on ethical grounds while actually doing nothing of the sort; presumably that sort of thing is just what S.E.C. oversight is intended to minimize (and we’ll return to the issue of misrepresentation below). But even if we assume that a fund’s managers are well-intentioned, that doesn’t mean that their fund’s status as “ethical” is a given. As lots of people have noted (and as is hinted at in the NY Times story) there’s legitimate debate over whether there’s anything wrong with the kinds of firms ethical funds typically filter out. Filtering out defence contractors, for example, is pretty open to debate. After all, making land-mines that blow kids’ legs off is bad; making the guns and flack-jackets necessary for peace-keeping is good. So, suffice it to say that investment funds of the kind we’re discussing here are filtering for a certain kind of ethics, a certain set of ethical concerns, rather than necessarily promoting ethical behaviour in all its forms. Of course, if I’m right in suggesting that the present case might not, strictly speaking, be a case of hypocrisy, that doesn’t at all reduce the wrong-doing here. But it does mean the smirk is a little off-target.

The second issue has to do with misrepresentation. This is clearly what the S.E.C. was (appropriately) concerned about. The S.E.C. doesn’t care about ethical filtering per se, but it does care that funds promising a certain kind of filtering actually follow through on that promise. Pax World was claiming to engage in a kind of filtering, and was apparently pretty regularly dropping the ball. Misrepresentation is a bad that pretty much everyone can agree on. People who buy (or just advocate) ethical funds want to be assured that they really are getting what they’re paying for. And hard-core free-market economists have to be equally concerned about misrepresentation (no matter how skeptical some of them might be about ethical funds and the intrusion they represent of non-obviously-economic factors into the marketplace). Investors in “ethical” or “socially responsible” funds are buying not just an investment vehicle, but an investment vehicle that lets them (attempt to) put their own values into action. And if the funds they buy don’t actually promote those values, investors aren’t getting what they’ve paid for and fund managers are guilty of promoting the kind of market failure that comes from information asymmetry. Basically, any time consumers don’t get what they’ve paid for, there’s a prima facie argument to be made that the market is operating inefficiently (i.e., there would be more net benefit — more satisfaction of individual preferences — if things were done differently).

The final issue has to do causation and intentions. There’s no doubt about the fact that Pax World dropped the ball in terms of the filtering it promised its customers. But there’s some question as to why and how. The impression one gets after reading Lieber’s NY Times piece is that, in all likelihood, the problem at Pax World involved sloppiness, perhaps combined with a shift in focus at the firm which resulted in a less-than-scrupulous attention to the values-based origins of their socially-responsible funds. It seems to me to be highly likely that lots of regulatory violations come about that way. As the saying goes, you’ll do better at understanding the world if you assume people are foolish than if you assume people are malicious. The S.E.C.’s job, of course, is to discourage violation of its regulations, regardless of the reasons behind such violations. The S.E.C. only needs to care about causation to the extent that it needs to decide whether to charge a firm with negligence or with intentional wrongdoing. Those of us who aren’t in enforcement roles, but who are more casual observers & analysts of ethical business conduct, can afford to wax philosophical. So I’ll end with questions for consideration: should we care why Pax World failed in the way it did, or simply that the failure happened? Was Pax World’s attempt at socially responsible investing enough to warrant praise, and was its partial failure enough to warrant (moral) criticism?

Related links:
Pax World Mutual Funds
U.S. Securities and Exchange Commission

1 comment so far

  1. Andrew on

    Chris,In response to two of the questions you pose – I feel that we should be concerned with both the fact that Pax World failed and with the causes of its failure.Issues such as disclosure and governance practices have been at the forefront of a considerable degree of criticism which has been directed at SRI funds by respected commentators such as Paul Hawken over recent years.Unfortunately, some funds do not provide adequate disclosure of (a) the specific criteria upon which potential investments are screened for suitability from an ethical standpoint, and (b) the research methodologies in which the fund employs in relation to the ethical practices of prospective investee companies.What is needed, in my view, is for the industry to work with other interested parties in the development of a framework for best practice standards in relation to corporate governance and disclosure. Prospective investors in SRI funds have the right to be provided with clear and specific information about the types of investments that the fund will and will not make. It is the responsibility of the industry to ensure that such information is available on a consistent basis.

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