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August 24, 2006
Domini Shareowners Approve Shift from Index Tracking to Active Management
by Bill Baue
The transition carries implications for investors, such as capital gains taxes, which Domini is
strategically mitigating.
SocialFunds.com --
On Monday, Domini Social Investments announced results
of a special meeting last week where shareowners approved of shifting the Domini Social Equity Fund
(ticker: DSEFX), a bellwether of
socially responsible investing (SRI), from passive index tracking to active management. After 15
years of tracking the Domini 400 Social Index (DSI) under exclusive license with index
provider KLD Research & Analytics, the fund will
commence active management by Wellington
Management Company on November 30, 2006. So the question arises, how will this transition
impact existing and new investors?
One of the primary financial considerations has to
do with potential exposure to capital gains taxes specific to index funds, according to SRI
financial advisor Bruce Herbert of Seattle-based Newground Social Investment.
"Whereas actively
managed funds tend to trade stocks more heavily, index funds tend to suppress trading, creating
some longstanding capital gains positions," Mr. Herbert told SocialFunds.com. "An actively managed
fund may have more capital gains 'events' happening, but the tax consequence of each individual
trade tends to be less consequential because positions are typically not held as long as in an
index fund."
"The schedule of when those capital gains 'unwind' in the process of
transitioning to an actively managed portfolio will determine when the rainy season of capital
gains will shower down on fund shareowners," he added. "It doesn't matter if an investor bought in
10 years ago or 10 hours ago--if tomorrow is the day Domini decides to unwind a position that has a
deeply embedded capital gain, it will register to those shareowners on the day it happens."
Domini will use two strategies to try to mitigate tax consequences during the transition,
according to Steve Lydenberg, chief investment officer at Domini.
"First, capital losses
on certain stocks will be used as much as possible to offset capital gains on others," Mr.
Lydenberg told SocialFunds.com. "Second, the transition period will take place over 60 days
spanning two calendar years, so that whatever tax consequences there are will be spread over two
tax years."
Domini is capping its expense ratio at 1.15 percent for Investor shares and
0.85 percent for R shares at least through the first year and perhaps beyond November 30, 2007.
"As an actively managed SRI fund, the new expense ratios are pretty reasonable," said Mr.
Herbert. "SRIs, because of their smaller size relative to mainline funds, tend to have higher
operating costs, but I think the new operating structure of the Domini is reasonable in the
marketplace."
The new incarnation of the fund will have a core holding of between 80 and
100 companies, according to Mr. Lydenberg. The focus will be on large- and mid-capitalization
firms, and Wellington will employ its style-neutral investment methodology that equally favors
growth and value stocks. The fund will also continue its tradition of holding some innovative
small-cap companies.
"For the purpose of highlighting companies with strong social
stories, the fund will take a number of positions that will usually be small relative to the
overall portfolio and will be in addition to the 80 to 100 core holdings," Mr. Lydenberg said.
Domini's decision to shift to active management has prompted some head-scratching in the SRI
community, trying to make sense of the move.
"It would have been a little more costly, but
it would have been great to develop an actively managed Domini fund to stand alongside the existing
passively managed Domini Index Fund," said Mr. Herbert. "The Domini name and history is so well
established in this arena that to give up what many might call a 'flagship' fund and fundamentally
change its nature is unfortunate."
"As you can imagine, the decision to move to active
management was a difficult one for Domini and made only after considerable deliberation," Mr.
Lydenberg said.
It was based on two lessons Domini has learned over the years from the
Domini Social Equity Fund.
"First, performance attribution shows that specific asset
selection, which can be equated with the social screening process, has added value to the fund over
the long run, and in various recent periods as well," explained Mr. Lydenberg. "Second, industry
biases introduced by these social standards--because of the market-capitalization weighting of the
index--helped the fund some times and hurt it at others.
"In recent years these industry
biases, including the fund's underweighting in energy, have often had the effect of undercutting
the positives gained from the social screening," he continued. "By shifting to active management,
we hope to be able to continue to capture the positives of the social screening and allow for
adjustments that will diminish the losses that the industry biases can introduce."
Mr.
Herbert laments the loss of an investment product to track the Domini Social Index--though of
course the index itself still exists to benchmark SRI performance against the S&P 500. However,
there are indications that this gap will be filled.
"There is active interest from
potential licensees for exchange traded funds and mutual funds, as well as separate accounts, based
on the Domini 400 Social Index," said Tom Kuh, managing director of indexes for KLD, which manages
and licenses the DSI.
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SRI World Group, Inc. All Rights Reserved.
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