The Morality of Mutual Funds, Part 3: Common Alternative Investments
So far in this series that began with the question of the morality of investing in mutual funds, we’ve been dealing with principles.  (You can review part 1 and part 2 of the series to get caught up on all that has been discussed so far.) It’s now time to start applying those principles practically.

In our last post we came up with an investment filter that can help evaluate the desirability of any given investment. Using this filter, I’ve created a quick at-a-glance scorecard for each investment below. While the criteria themselves can be helpful for anyone, not everyone may score them exactly the same.  So let’s take a closer look at how I’m approaching these criteria before getting to the exact investments.

Investment Filter

  1. Do I understand how it works?/Is it easy to understand? (YES/NO) – This is a subjective filter but will affect the significance of the later points, but it is something that you need to answer honestly. Don’t let your emotions cloud your judgment on this one.  But for the sake of my rating system, I’m simply asking the question of whether it’s easy for the uninitiated to gain the essential knowledge, where YES is preferred to NO.  Your own answer may vary depending on your level of knowledge.
  2. Is it speculative? (YES/NO) – Rarely is speculation determined by the type of asset, but rather how an individual plans to treat that asset. For example, real estate investing isn’t usually speculative, but people can and do speculate in real estate all the time.  So this score is based on how those assets are TYPICALLY treated, and NO is better than YES.
  3. Is it low cost? (LOW/HIGH) – Generally speaking, an investor should strive to keep their investment costs as low as possible. A hedge fund may return 25% in a year, but after the management fees, transaction fees, and such you may end up with closer to 10%.  An index fund may only return 11% in a year but having only a 0.05% expense ratio means you’ll actually end up ahead of the hedge fund.  Compounding costs will negate the benefits of compounding interest.  So a LOW rating is better than a HIGH rating in this category.
  4. How much time does it take to manage? (LOW/HIGH) – I think it’s safe to say that for most people, the less time an investment requires, the better.  If it takes an inordinate amount of time to manage, I would no longer classify it as an investment but rather more as a second job or at least a serious hobby.  So the rating is from LOW to HIGH, where LOW is better.
  5. Is it an acceptable amount of risk? (LOW/HIGH) – This will largely depend on your personal risk tolerance as we discussed in the last post, so it will vary from person to person.  So my score may not be the same as your score.  Young people probably can take on more risk with their money while older people probably shouldn’t.  But for my rating system here, it’s also measuring from LOW to HIGH where LOW is better.
  6. Is it diversified or easy to diversify? (YES/NO) – Some investments come with diversification built-in as one of the objectives, while other investments don’t. Some investments can be easily diversified because of low capital requirements whereas others require such high capital that diversification is difficult for most lay-investors.  This is an important factor to consider in assessing the overall portfolio.  So YES is better than NO.
  7. Does it beat inflation over the long-term? (YES/NO) – One of the key reasons we invest in the first place instead of just stashing our money in our mattress is to beat inflation. We need to keep ahead of the erosive effect of inflation or else we’re losing money.  YES is essential, NO means it’s not actually a successful form of investment for the long-term at all.
  8. Is it easy to liquidate? (YES/NO) – In general, the easier to liquidate, the better an investment. It offers greater flexibility in case of withdrawal, and it creates more options for the investor.  So YES is better than NO.
  9. Is COMPLETE indirect moral purity possible? (YES/NO) – As discussed in part 1 of this series, we want to steer clear of any direct involvement with immoral businesses, but avoiding all indirect involvement isn’t really realistic.  Thus while we should do our best with our investments, it shouldn’t be the one filter that overrides all of the others.  So for the purpose of this series, I’ve included this criteria for the sake of comparison.  A YES in this column simply means that it is possible to have COMPLETE confidence that an investment is free of any indirect immorality.  If there remains ANY doubt about the indirect morality, it gets a NO.  So a YES in this column is better than a NO.

In this post we will apply this filter to some of the most common forms of investments available.  These are the most probable options you will encounter in everyday life.  There are a gazillion forms of investments and we certainly aren’t able to cover them all here, but maybe we’ll look at some other ones in the future.

Let’s take a look at some actual investments now.  Each section will start off with the scorecard followed by commentary on categories that may need more explanation.

Savings Account/CDs

1. Understand? Yes 6. Diversification? Yes
2. Speculative? No 7. Beats Inflation? No
3. Cost? Low 8. Liquidity? Yes
4. Time? Low 9. Morality? No
5. Risk? Low Score:  7

I’ve heard people ask why anyone would ever put money into anything that has the possibility of losing money?  Why not just put it in an FDIC-insured account and be done with it?

Beating Inflation: Simply because over the long-term, doing that will guarantee us losing purchasing power.  The interest rates in bank savings accounts and CDs don’t beat inflation (at least currently in the US), and thereby is a surefire money-loser over the long run.  It is equivalent to burying our talent in the ground.

As a short-term vehicle for saving (i.e. capital preservation), these accounts are great.  I use them for things like our emergency savings fund or our savings for a new car, but for money invested for 5 years or more, I look elsewhere.

Morality:  Also, is allowing a bank to invest our money really the most moral option?  (Have you seen the news surrounding Wells Fargo lately?)  Who are they lending that money out to that pays my interest?  The question is not if they lend to unethical recipients, but how much.


1.     Understand? Yes 6. Diversify? Yes
2.     Speculative? No 7. Beats Inflation? No
3.     Cost? High 8. Liquidity? No
4.     Time? Low 9. Morality? No
5.     Risk? Low Score:  5

Individual bonds are loans that you issue to an organization in need of cash.  It might be a business or a government entity.  US Treasury bonds are loans to the US Federal Government and are considered the safest investments available currently on the planet.  There are also municipal bonds (affectionately nicknamed “munis”) which are loans to municipalities, and corporate bonds are loans to companies.

Liquidity: With direct bond purchases, you won’t be able to get your money back until its full maturity, so liquidity could be a problem unless you are willing to sell on the secondary bond market.

Cost:  The commissions for trading bonds are usually pretty high as well.

Beating Inflation: Some corporate bonds come with fairly high interest rates and commensurate greater risk (sometimes referred to as “junk bonds”), whereas most government bonds have lower risk but barely keep pace with inflation (at least currently).  The exception are TIPS (Treasury Inflation-Protected Securities), which are guaranteed to keep pace with inflation, but you shouldn’t expect to earn anything beyond that.  Also, municipal bonds can be tax-free.

Diversification: As far as diversification is concerned, bonds (particularly when held in bond funds) are usually recommended as counterweights to stocks in an investment portfolio because they aren’t correlated assets (meaning they don’t tend to move together in the same direction).  So while they may not be the high-yielding, inflation-beating core investment engine that drives a portfolio, they can be utilized as ballasts to steady the volatility of stocks in a portfolio.

Morality: However, if an investor has moral concerns over stocks, those concerns should be at least as great if not greater with bonds.  Any direct bond purchased from a corporation or government is money being loaned to that entity.  The investor really is giving money to that organization to conduct its affairs.  If they are involved with evil, then our money has gone to aid that.

Even government bonds bring questions regarding indirect immorality as they are involved in lots of morally questionable activities. If we are against mutual funds holding defense contractors/weapons manufacturers, then with US Treasuries we’re aiding in the actual military, just as one example.  Plus, the interest from the bonds are paid for from taxes that come from the very immoral companies that we were trying to avoid in mutual funds in the first place.  If stock mutual funds aren’t acceptable for moral reasons to an investor, then bonds probably wouldn’t be acceptable either.

Individual Stocks

1.     Understand? No 6. Diversify? No
2.     Speculative? Yes 7. Beats Inflation? Yes
3.     Cost? High 8. Liquidity? Yes
4.     Time? High 9. Morality? Yes
5.     Risk? High Score:  3

Many individuals believe that buying individual stocks of companies that are morally upstanding is the best solution.  Indeed, it’s possible to search out those businesses that fully align with your values when you take this approach.  While I don’t see investing in individual stocks as wrong necessarily, I don’t believe it is wise as the primary investment strategy for most lay investors for a number of reasons.

Diversification: Unless you have a lot of money to create your own investment mix, it’s difficult to achieve a widely diversified portfolio. 

Time: And in order to do that, it takes a lot more time.  It would require a great deal of research into each individual business that you’re investing in, and continual monitoring to keep up with changes in the business.

Risk: While having greater knowledge in the businesses can reduce the risk, it takes a lot of time as previously mentioned.  But nevertheless, it is always a great deal riskier to invest in individual businesses because there will always be unknowns that can never fully be predicted.  (Just review the CNBC tapes on Lehman Brother’s right before the 2008 crash.)

Speculative: And typically when people say they want to invest in individual stocks, they mean they want to TRADE stocks.  That means timing the market (academically proven to be a loser’s game), or for the truly ambitious, trading on margin (or borrowed money).  It’s rare to find a disciplined buy and hold investor in individual stocks.  Most of the time they’re listening to guys like Jim Cramer, doing technical analysis on stock charts, and talking about 50-day moving averages and support levels and other jargon.  Don’t fall for that stuff.  That’s speculation, pure and simple.

Costs: Also, with most brokerages, stock trading comes with relatively high costs—especially for small investors.  Moreover, with frequent buying and selling, an investor can accrue lots of short-term gains taxes that they are liable for in the current tax year.  Buyer beware.

Socially Responsible (SRI) Mutual Funds

1.     Understand? Yes 6. Diversify? Yes
2.     Speculative? No 7. Beats Inflation? Yes
3.     Cost? High 8. Liquidity? Yes
4.     Time? Low 9. Morality? No
5.     Risk? Low Score:  7

Enterprising proponents of the view that we should never invest in mutual funds that contain immoral businesses have created a class of mutual funds that have been morally filtered to answer this need.  Broadly they are called “Socially Responsible Investments”, or SRI for short.  Some Christians prefer the term “Biblically Responsible Investments” or BRI.  While I can appreciate their reasoning, I also have some issues with them.

Cost: Because the screening process is laborious, it requires increased management which means SRI funds usually come with significantly higher cost than comparable index funds.  That higher cost inevitably eats up investment returns.  Not to mention, many SRI funds don’t just filter out the bad companies from an index, the managers also try to apply their own active management strategies to the fund.  This further increases the management expenses, but worse, rigorous academic studies on actively managed funds show that over 80% of them lag their benchmark index—meaning, they perform poorly.

Morality: However, the biggest problem with SRI funds is that there’s no telling that their moral screen actually matches our own.  There are many SRI funds each catering to a different niche of morality.  Some are politically left-leaning, and so the things they filter for may actually be in direct conflict with Christian values.  Some are specific to certain faiths like “Halal” funds for Muslims, and “Ave Maria” funds for Catholics.  So just because a fund is labeled as “socially responsible” or “ethical”, it may not mean what you think it means.

For example, you may want to avoid pharmaceutical companies that support abortion whereas some SRI funds may not screen for that.  Or a fund may hold Starbucks for its commitment to environmentalism and human rights, but you oppose them because you believe caffeine is a harmful substance.  Even if you find a Christian values-based SRI fund (The Timothy Plan being the oldest and most well-known), there are enough variances in values between Christians of different denominations (even WITHIN denominations!) that it’s nearly impossible to find one that matches our views precisely. (For example, the Timothy Plan funds don’t appear to filter out defense contractors or weapons manufacturers at all.)  What’s more, just like with regular mutual funds, it’s nearly impossible to see what the actual holdings are at any given time.

While I can applaud the effort and motives of SRI proponents, and I also respect individuals who choose to invest in them in an effort to do the best they can to limit the evils in their indirect associations, my basic contention with SRI funds is that I am paying more for lower performance all for a moral screen that still doesn’t match my own. It seems a bit to be like paying more for nothing.

Real Estate

1.     Understand? Yes 6. Diversify? No
2.     Speculative? No 7. Beats Inflation? Yes
3.     Cost? High 8. Liquidity? No
4.     Time? High 9. Morality? Yes
5.     Risk? High Score:  4

Real estate is a good investment for those looking for a morally pure option because it’s possible to screen for tenants and only rent to those that you trust.  There’s very little moral ambiguity here.  However, there are still a lot of other factors to consider.

Time:  Managing real estate can easily become a second job.  A great deal of time and energy are required to look for renters, interview them, show the property, deal with their problems, evict them if they don’t pay, fix the place up in between, extra hassle in filing taxes, etc.  Landlording isn’t a gig for everyone, that’s for sure.

Cost:  It takes a great deal of capital to get into real estate.  It’s hard to get started in rental properties with your first $1000 of investment capital.  But even if you do have the money, there are loads of costs to maintain the investment.  Maintenance/repair/renovation of the building, advertising costs for tenants, property taxes, mortgage/interest payments, insurance, HOA fees, management fees if you use a property manager, etc.  While not specifically addressing rental real estate, you can check out this previous post about whether our personal residence qualifies as a good financial investment.

Risk:  While owning real estate may not look like a high-risk investment, property is typically purchased with a mortgage.  Once you introduce a large amount of debt into the equation, it changes the risk profile significantly.  What happens if disaster strikes (i.e. economy tanks, you get laid off, you can’t find a renter, etc.) where you are no longer able to make the minimum payments?  Moreover, there’s also the problem of diversification.

Diversification: Because real estate is a large investment, it’s not easy to become diversified unless you’ve got a lot of money.  It’s a lot just to scratch together enough capital to own two rental properties, but if both of them are in Southern California, the investment still isn’t well diversified from a big earthquake, is it?

Liquidity:  Have you ever tried to sell a house?  You’ll know that it is far from liquid.  It is difficult to offload real estate, and one should hope that it’s not a down market when the day comes that they need to.

Real estate certainly has its benefits, but there are plenty of very real challenges for people wanting to get into it.  So much so that it may not even be a realistic option for many folks.

REITs (Real Estate Investment Trusts)

1.     Understand? Yes 6. Diversify? Yes
2.     Speculative? No 7. Beats Inflation? Yes
3.     Cost? High 8. Liquidity? Yes
4.     Time? High 9. Morality? No
5.     Risk? High Score:  5

I wrote a blog post about How to Invest in Real Estate Without Owning Any where I shared about REITs.  They can certainly play a part in a diversified portfolio, but REITs come with a lot of similar considerations as individual stocks, because that’s what they are.

Time & Cost: Primarily in the time it’ll take to properly evaluate them and the transaction costs (just liked stocks).

Morality: Moreover, there is still the morality question of the type of businesses that these real estate companies are involved with.  Casinos, restaurants/hotels that serve alcohol, strip clubs, liquor stores, bars, abortion clinics, etc. may find themselves into the holdings of various REITs and mREITs, and they will certainly be in any REIT fund that are available.

Active Mutual Funds

1.     Understand? Yes 6. Diversify? Yes
2.     Speculative? No 7. Beats Inflation? Yes
3.     Cost? High 8. Liquidity? Yes
4.     Time? Low 9. Morality? No
5.     Risk? Low Score:  7

So this entire series of articles kicked off with a question on mutual funds, so I suppose it’s only right to run them through our filter as well.  Especially since these are the most common options (sometimes ONLY option) available to investors in most retirement plans, it’s more than likely that you will run into them at some point.  Mutual funds come in many flavors.  There are stock or equity funds which hold stocks, bond funds that hold bonds, commodity funds, real estate funds, and every variation and combination in between.  But most of the time actively-managed equity funds are what people refer to when they say mutual funds.

You may be surprised to know that I’m not exactly the biggest fan of most mutual funds either.  But first, here are some benefits of mutual funds.

Diversification:  This is a feature that’s built into the entire objective of mutual funds.  With sometimes as small as a $100 investment, an investor can be diversified across hundreds of businesses or bonds.  This also greatly reduces the risk in the investment.

Speculation:  As an investment vehicle, they are designed to not be speculative.  Investors are punished for jumping in and out of mutual funds, discouraging the speculators. However, active mutual funds can still be speculative inherently based on the strategy of the fund manager or the narrowness of the fund objective. Not all mutual funds are created equal either. Mutual funds do have some of the best disclosures of any financial instruments though, so if you’re willing to read the fine print, it’s more likely to understand what the fund manager is actually trying to do than in other forms of investments.

Time:  Mutual funds take almost no time to manage.  They can be set and forget, especially if they are placed on an auto-investment program.  This is one of the reasons why they are the most popular options offered in most retirement plans.

Liquidity:  One of the best features of mutual funds is that they can be sold within one business days in nearly all cases.  Factoring in the transfer time to the bank, a mutual fund can be completely liquidated within a handful of days in a worse-case scenario.  So they are quite liquid. They are less liquid, however, than single stocks which can have nearly instantaneous execution. It’s also noteworthy that fund managers have the right to close the fund to new investors, or to limit your ability to withdraw in the case of a financial emergency, so there are special circumstances that could limit liquidity.

Costs: This is the greatest reason why I’m not the biggest fan of mutual funds despite all their benefits.  Many mutual funds come with high costs in the form of front-side/back-side loads, marketing fees, management fees, high expense ratios, and more.  Frequently, financial advisors get commissions from selling certain funds, which incentivizes them to sell you something that might not be the best for you simply because it pads their pockets.  Beyond that, as mentioned earlier, active management underperforms their benchmark indexes over 80% of the time.  Finally, to add insult to injury, frequent trading within mutual funds (true of many actively managed funds) results in greater taxes passed on to the fund holder.  Many mutual fund owners get “nickle and dimed” to death with all of the hidden costs.

Beats Inflation:  Some mutual funds have beaten inflation over the long-term even if they don’t keep pace with their benchmark index. However, this is not guaranteed depending on the type of assets held within the fund and also the quality of management.  It’s not unheard of for many poor performing mutual funds to simply get shut down or merged into others before they completely crater.

Index (Passive) Mutual Funds

1.     Understand? Yes 6. Diversify? Yes
2.     Speculative? No 7. Beats Inflation? Yes
3.     Cost? Low 8. Liquidity? Yes
4.     Time? Low 9. Morality? No
5.     Risk? Low Score:  8

Pioneered by John Bogle of Vanguard over 40 years ago, index funds seek to provide all of the benefits of mutual funds while addressing all of their weaknesses.  Index funds adopt a passive investment strategy as opposed to the active strategies that I’ve railed against.  “Passive” simply means that it doesn’t seek to beat the market benchmarks, it selects an index and tries to match it by owning exactly what the index does.  History has proven that this strategy is vastly superior to active management.

The biggest reason is that it significantly reduces the cost of investing.  Because the passive strategy simply requires matching an index, it doesn’t involve nearly as much resources as active management does.  So as a result, an index fund may cost as little as 0.05% while an actively managed mutual fund averages around 1.25% currently (not including any loads that could be another 5% or so above this).  The index fund is 25 TIMES cheaper.  That kind of difference adds up significantly over the long run, and contributes to why they perform better than the vast majority of regular mutual funds.

Of course, index funds retain all the benefits of mutual funds as well such as diversification, ease of understanding, ease of management, and liquidity.

ETFs (short for Exchange Traded Funds) are a special flavor of index funds that are traded like stocks.  So it can be lower cost in some cases (if you can escape the commissions and transaction fees) and have the same liquidity of a stock (meaning it can be sold almost instantly whenever the markets are open).  This also means that it is much easier to speculate in ETFs which will require self-control on the part of the investor.

The Morality Question

In looking over the investment options in this post, it appears to me that if we have a moral discomfort against mutual funds and index funds, the same or greater discomfort would apply to most of the other investment options discussed.  With the exception of real estate investing, all of the other assets have some indirect association with evil.

Perhaps you find one of the other options less objectionable, but I’m left with the persuasion that when everything is taken into account, index funds remains one of the best investment options for most people.  It certainly isn’t perfect, but it comes the closest to meeting the greatest number of the investment filters outlined at the beginning of this post.

Applying the Scorecard

Although in my evaluation some of investments scored higher than others, it doesn’t mean that I just jettison all of them and ONLY invest in the highest scoring one.  For the sake of diversification, it’s still helpful to hold different types of assets and these scorecards can help us determine what to use as our core holdings, what to use as supporting holdings, and how to allocate them.

For my personal investments, I use index funds as the core of my portfolio (in both regular fund and ETF variants) and balance it with bond funds primarily.  I supplement it with a few percentages of REITs and have been known to dabble with a few individual stocks on occasion.  I also own my own home which has a small rental unit on the property. This is the extent of my foray into real estate.  I also have money in savings accounts and CDs for short-term needs.

You may come to a different conclusion in your own mind and decide to invest differently, which of course is fine, but hopefully this series has given you some ideas on how to evaluate your investment options and build a balanced investment portfolio that achieves your goals but still preserves a clear conscience.

What do you think?  There are plenty of other types of investments that I didn’t mention.  Let us know if there are any that you’d like to see get run through this filter.

Check out the other parts of this series: