An increasing number of mutual fund investors want to incorporate their social values into their investment approach. Environmental, social, and governance (ESG) criteria create a framework to help them achieve this. As the name suggests, the ESG screening process identifies companies that have built sound environmental practices, strong social responsibility tenets, and ethical governance initiatives into their corporate policies and everyday operations.
Small-cap companies–those with stock market capitalization between about $300 million and approximately $2 billion–are considered riskier investments compared with mid- and large-cap companies, but they typically also have significantly higher growth potential, possibly offering investors an opportunity to land that coveted stock that multiplies 10 or 20 times in value.
While they could yield big gains, investing in these funds can come at a cost. Expense ratios for funds that consider ESG factors can vary widely. Paying more in expenses will reduce your returns over time.
Watch out for the minimum investment required for such funds–it was typically $1,000 for many we reviewed, but it could go as high as $2,500 or more, depending on the brokerage you invest with.
Morningstar, a financial services firm that provides investment research and management, has developed its own rating system for sustainable investments, which many other financial organizations have adopted. Here is a summary of five smaller-cap mutual funds that are rated highly in general by Morningstar analysts, presented in order of those ratings, descending from five stars.
Calvert Small-Cap A (CCVAX)
This fund, offered by Calvert Research and Management, a pioneering ESG investment fund manager started in 1976, earns a top, five-star overall fund rating from Morningstar analysts. The fund invests at least 80% of its holdings in smaller, lesser-known companies in the Russell 2000 index, which measures the performance of 2,000 smaller U.S.-traded companies.
As of March 31, 2021, the fund had $2.5 billion in assets under management (AUM) and, as of April 30, had returned 14.88% over three years compared with 15.21% for the Russell 2000. Over ten years, the Calvert fund’s average annual return has been 11.7% versus 11.62% for the Russell 2000. The expense ratio is 1.21%.
Shelton Green Alpha Fund (NEXTX)
Morningstar also gives this fund its highest rating of five stars. Holdings in the fund may lean in capitalization toward mid-cap companies and even some large-cap companies, while maintaining an emphasis on potential growth from green economy companies. The fund is benchmarked against the MSCI ACWI Investable Market Index, which comprises more than 9,000 companies across market capitalizations worldwide.
As of March 31, 2021, the fund had $273.8 million AUM. It saw a spectacular one-year return of 169.44%, compared with 57.58% returned by its benchmark, not surprising because Tesla and Moderna feature among its top holdings. Its three-year annual return is 39.19% versus 11.89% for the MSCI ACWI IMI index. Note, however, that this fund carries a hefty expense ratio of 1.28%, and the minimum investment required is $1,000 unless it’s an automatic investment account, for which the minimum is $100.
Parnassus Mid-Cap Fund (PARMX)
As the name suggests, this is technically not a small-cap fund, but it has some small-cap holdings. The Parnassus Small-Cap Fund (PARSX) was merged into PARMX, which garners a five-star rating from Morningstar.
The fund normally invests at least 80% of its net assets in mid-sized companies and may normally invest up to 20% of its net assets in smaller- and larger-cap companies. It seeks to outperform the Russell Midcap Index over the long run while shielding investors in down markets.
As of March 31, 2021, its assets totaled $7.4 billion, and its return performance over three, five, and ten years of 13.22%, 13.12%, and 11.61%, respectively, has underperformed the Russell Mid-Cap Index by less than one percentage point. Its expense ratio is 0.99%, and it requires an initial minimum investment of $2,000 from individual investors.
Pax Small Cap Fund (PXSCX)
This fund that’s rated three stars by Morningstar analysts is managed by one of the more seasoned U.S. ESG investment firms, Pax World Funds, which started in this arena in the 1970s. The Small-Cap Investor fund was launched in 2008 and states that it focuses on small, high-quality companies at reasonable prices.
It posted an eye-catching return of nearly 80% in the year to March 31, 2021, although its year-to-date (YTD) performance in 2021 has been more subdued at 13.69%. Over the longer term, its performance across three, five, and ten years has hovered around 10%, often underperforming its benchmark Russell 2000 Index by a few percentage points. This fund, with about $570 million AUM at the end of 1Q 2021, has fossil-fuel-free holdings, according to Pax World Funds. The fund’s expense ratio is a little higher than average for its category at 1.2%.
Praxis Small-Cap Index Fund Class A (MMSCX)
The fund seeks to reflect the performance of the U.S. small-cap equities market by tracking the S&P SmallCap 600 Index, but applies ESG screening to its investment process and commits 1% of its assets to “community development investing.” While most of its allocation is dedicated to small caps, the fund’s top holdings do include GameStop and Macy’s. Rated two stars by Morningstar, this fund had $150.7 million in assets as of March 31, 2021.
It clocked a three-year performance of 11.27% (13.3% for the no-load fund) versus 13.71% for the S&P SmallCap 600 Index. Over the five-year period, the Praxis fund returned 11.46% (12.66% for its no-load fund) as compared with 15.60% for its benchmark index. The fund’s expense ratio of 1.12% is expensive for an index fund, and you must keep in mind a 5.25% sales charge unless you’re opting for a no-load fund. The fund also charges a $25 annual fee to accounts under $5,000 and requires a minimum investment of $2,500.
Where Socially Responsible Small-Cap Investing Is Headed
Morningstar reports that ESG investing practices gained momentum in the early 2000s but have their roots in investment screening done for generations to conform to religious and ethical beliefs. By the 1970s, activists opposed to the Vietnam War started advocating for socially responsible investing, and the first sustainable mutual funds were established. A common concern about following ESG investing guidelines is whether that choice produces returns that trail broader market indexes.
Morningstar compiled the 2020 net returns of all stock and bond funds that had a sustainability rating as of Dec. 31, 2019. It reported that, when compared with the index funds each tracked, the ESG funds that courted less ESG risk beat their style-specific index more often than ESG funds that offered greater exposure to a larger amount of risk.
“Funds with higher ESG ratings also bested their benchmarks by larger average margins than funds with lower ESG ratings. In other words, there was a better average payoff to investing in funds that courted less ESG risk,” Morningstar said.
Assessing a single year’s return is not enough to gauge the long-term impact of ESG investing. Morningstar states that further analysis is necessary to accurately gauge the relationship between ESG risk and investment performance.
While many stock mutual fund investors wish to invest only in companies that reflect their values, it’s still a good idea to diversify by investing in established large-capitalization companies as well as mid-cap and small-cap ones.