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Do-gooders emerging in emerging markets funds

A woman working in a textile factory in Huaibei, China
AFP | Getty Images
A woman working in a textile factory in Huaibei, China

Nelson Mandela galvanized the socially responsible investment (SRI) movement when he called for people and institutions to sell holdings that supported South Africa's apartheid regime. It's taken 30 years for the investment companies to start catching up to Mandela when it comes to emerging markets.

A tiny handful of funds now allow investors who want to follow their conscience and invest in developing market economies. Three companies known for socially conscious or religiously-themed investment strategies have created emerging markets funds in the past two years, adding to a Dimensional Fund Advisors' ethical emerging markets portfolio that's been available since 2006.

"A few years ago I would have said you can't do [socially responsible investing in emerging markets] at all," said J. Chris Cogswell, a Louisville, Ky.–based advisor with Portfolio Resources Group, a boutique firm that manages nearly $1 billion and emphasizes socially responsible investing. "I'm not going to say you can't do it now, but it's hard."

(Read more: Time to overcome your fear of Chinese stocks)

Demand for investment products that are filtered in one way or another is rising. Some funds filter out some companies—tobacco companies and petroleum producers are two common types—or filter in companies known for responsible strategies. More than 1 in 9 dollars under professional management in the United States, or $3.74 trillion, was invested in SRI strategies in 2012, up from $3.07 trillion in 2010, according to the Forum for Sustainable and Responsible Investment.

Until recently, emerging markets has been the forgotten stepchild of the socially responsible world, for a few reasons: Information is harder to come by for companies operating in emerging markets, and the emphasis in emerging economies tends to be on growth rather than sustainability, ethics or governance.

The choices remain limited, too, and can be expensive. The net expense ratio on these funds ranges from 0.75 percent to 3.76 percent, according to Morningstar, though some of the ethical emerging markets funds have outperformed benchmarks.

(Read more: ETF investors pour billions into country funds)

But the outperformance of emerging markets over the last decade—emerging markets was the top-performing asset class in seven of the last 10 years—has increased the pressure on fund companies to add emerging markets portfolios. Many advisors now suggest that emerging markets should comprise as much as 20 percent of a diversified portfolio, depending on your risk tolerance.

Bethesda, Md.–based Calvert Investments introduced its fund in response to demand from advisors and investors, said Bennett Freeman, senior vice president for sustainability research and policy. The Calvert Emerging Markets Equity A fund, introduced in October 2012, was up 3 percent year-to-date as of Dec. 27. The iShares MSCI Emerging Markets Index exchange-traded fund, a proxy for emerging markets, has lost 7 percent this year, as of Dec. 27. The Calvert fund has roughly $44 million in assets; the fund has a net expense ratio of 1.76 percent.

"In emerging markets, the societal checks and balances to keep companies honest may be fewer [than in developing markets]." -Loic Dujardin, director of research products, Sustainalytics

If you want to invest ethically and still gain exposure to emerging markets, you have a few choices.

Investigate the handful of ethical emerging markets funds. In addition to Calvert, two other fund companies—Timothy Plan and Epiphany—have introduced emerging markets SRI funds. Because the funds are so new, it's not yet clear how much following your conscience in emerging markets will cost you in terms of returns. The Timothy Plan Emerging Markets A is down 1 percent this year, and the Epiphany FFV Latin America A, which has a narrower geographic focus, has lost 10 percent this year.

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Maitland, Fla.–based Timothy Plan invests with filters aligned with a Christian worldview of evangelical pastors, according to its website. Irving, Texas–based Epiphany also takes a faith-based approach.

Morningstar identified two other funds as having a socially responsible bent: the DFA Emerging Markets Social Core Equity Fund, the first-of-its-kind, and the American Century NT Emerging Markets Institutional Fund. The latter filters out tobacco stocks (NT stands for No Tobacco). Dimensional Fund Advisors' portfolio has a five-year return of 16 percent, according to Morningstar, which also claims the iShares MSCI Emerging Markets ETF is up 13 percent in the past five years.

Freeman said Calvert Emerging Markets Equity A, managed by London-based portfolio manager Hermes Investment Management and sold through advisors, looks both for companies making a positive impact in emerging markets, such as those adopting fair labor practices, and filters out companies making a negative impact, such as big polluters. "Increasingly, Calvert is a broad church that fills its pews with worshipers at both altars," said Freeman.

(Read more: Ethical investing comes of age)

Consider stock picking. You might buy a broad index–based traditional emerging markets fund and then set aside some money for what's known as impact investing—buying into companies that support a cause you care about.

The 100 global companies perceived to be socially responsible, ranked by the New York City–based Reputation Institute, could be a good place to start. But be warned that this kind of research is incredibly complex. Take, for instance, the question of investments in real estate in India. Investing in real estate could be seen as a profitable and socially responsible investment because it is spurring economic development in India. But developers there, particularly in hot property markets, are often in direct conflict with local residents for scarce water, and some are tapping into precious groundwater. On top of that, how will you get the real story of a particular company's behavior or impact?

"In emerging markets, the societal checks and balances to keep companies honest may be fewer [than in developing markets]," Loic Dujardin, director of research products for Amsterdam-based research firm Sustainalytics, wrote in an email. "However, investors have begun to rely on several non-company information sources—e.g., NGOs or local media. This provides a fuller and multi-stakeholder perspective of the company and moderates the company's own message and information."

Use an outside-the-box option. Some of Cogswell's clients buy notes from the Bethesda-based Calvert Foundation, a spin-off of the investment company. The foundation makes loans to microfinance organizations and packages them as investments that have a fixed term, usually ranging from one to five years, and a fixed interest rate comparable to what investors would get from a CD. Withdrawals prior to term are subject to tight restrictions, and the money and the return aren't guaranteed, though "they've never lost a penny of investors' money," Cogswell said.

If you want some exposure to emerging markets in your portfolio but your emphasis is on the ethics, this approach might work for you.

By Elizabeth MacBride, Special to CNBC.com

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