Putting good-old-boy network to the investor test

Following the death of Kevin Mossier, the pioneering founder of gay travel company RSVP Vacations, the trustees of the foundation he left behind wished to honor Mossier's activist spirit by solely investing in companies exhibiting progressive LGBT workplace standards.

But back in 1998, a time when The National Gay and Lesbian Chamber of Commerce didn't even have a website, the trustees had a problem: There was no index available for which they could base their investing mandate. They approached Denver Investments partner John Roberts to design a portfolio of companies with progressive workplace policies on sexual orientation, including health benefits for same-sex partners.

The Workplace Equality Index resulted from that effort. It has attracted more than $10 billion in institutional assets, and this year Denver Investments took the next step, launching The Workplace Equality ETF with the goal of convincing the market that diversity can make for a successful retail investment.

Whether The Workplace Equality ETF and other diversity-themed ETFs can show a performance edge remains an open question, and it's a question that has dogged the entire sphere of socially responsible investing. Roberts believes the ETF has history on its side, even if performance data has fallen a little short of making his case so far. Since inception earlier this year, EQLT has climbed just over 7 percent, falling short of the S&P 500 Index.

The investing trend's track record is simply too short to judge: Only 4 of the 7 ETFs that ETF.com includes in a principles-based category have a full year of performance, and all three of the pure play ETFs on the diversity theme launched within this year, including Workplace Equality, so they lack even a true year-to-date performance figure.

An undeterred Roberts said, "For the last 10 years, the underlying index has pulled in 10.4 percent per year vs. 7.5 percent per year for the S&P 500."

Others contend that the performance battle being waged by diversity funds will always be incidental to a larger cause: the psychological impulse within some investors to make the world a better place.

"Investors don't go into a diversity fund because they think it's going to be the best-performing equity ETF in the marketplace," said Todd Rosenbluth, director of ETF research at S&P Capital IQ. "They know these funds are unlikely to match the performance of a large-cap growth ETF attached to the Russell 1000." He compared an investment in a diversity fund to any niche asset class, and in contrast to the core large-cap equity portfolios, such as emerging market equity or small-cap health care.

The Workplace Equality ETF does hold its fair share of blue-chip stocks: General Electric, Apple, Cisco Systems, and Emerson Electric.

The Pax Ellevate Global Women's Index Fund—launched in June by Pax World Funds and Wall Street veteran Sallie Krawcheck—includes household names such as Coca-Cola, Nike, Microsoft, Google and Walt Disney.

"These blue-chip companies could really be a core holding for any investor," said Joseph Keefe, president and CEO of Pax World Funds.

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Keefe said diversity of staff and a company's bottom line are irrefutably linked. The Pax Ellevate fund, which is a traditional index fund rather than ETF, benchmarks against the MSCI World Index to invest in some 400 globally top-rated companies when it comes to representation of women in the boardroom and in senior management (the MSCI World Index has 1,631 stocks).

One hundred percent of the companies in the fund have at least one woman on the board; 97 percent have two or more; 69 percent have three or more. Average overall board membership is 31 percent women versus 11 percent globally, while 24 percent of management positions are held by women versus 11 percent globally.

"When you reach a critical mass of women on boards—approximately 30 percent—board behavior begins to change and the discussion becomes richer," Keefe said. "And when that good old boy network breaks down, governance improves. Diversity brings different perspectives and better ways of solving problems."

Without a track record, however, it will take some time for the investments to back up Keefe's assertion. The same holds true for Barclays Bank's Women in Leadership ETN, whose index tracks companies either with female CEOs or with women occupying at least one-fourth of the seats on a board.

"There isn't data I've seen showing socially-responsible companies with well-diversified boards are better stocks to invest in," Rosenbluth said, but he added, "There isn't data that says they're worse."

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ETF consultant Christian Magoon said the investing issue with niche funds—whether they're socially screened based on corporate leadership, environmental accountability or supply-chain concerns—is that by design, they can invite unpredictability. "The very variables that some funds focus on may cause them to take overweight positions in certain industries because they won't invest in others," Magoon said.

For example, by not investing in traditional fossil fuel companies that make up a material percentage of the S&P 500, investors can't benefit from the performance of that sector. If tobacco companies are excluded, other industries will be overweighted, and that can introduce portfolio biases that affect performance.

"This can be good or it can bad, but it's important to understand how those allocation decisions will dictate performance," Magoon said.

Creating and rebalancing diversity ETFs is typically more labor intensive than managing broader equity ETFs, and that can result in a higher fee structure than investors have come to associate with low-cost index ETFs. Where ETF fees average 55 basis points, the Pax Ellevate Global Women's Index Fund charges 75 basis points for its institutional shares and 99 basis points for the individual investor share; The Workplace Equality ETF has a 75 basis-point fee.

"One of the appeals of an ETF is that it typically has a low expense ratio, and a 75 basis-point expense ratio makes it harder for an ETF to outperform an S&P 500 Index-based product that charges less," Rosenbluth said. An S&P 500 Index ETF can have a fee as low as 5 basis points. But Rosenbluth added, "There's not a lot of niche funds out there, so if this is your priority, the costs may be worth it."

Roberts expects the fees to come down over time if the ETFs can gain marketing momentum: "A 75 basis-point fee is a little higher than it will eventually be. We intend to drop those fees over time as assets build."

In an exchange-traded fund market that now features more than 1,600 options, asset gathering is typically a make-or-break issue. "While it's good that there are more funds catering to investors' needs, their survival depends on whether or not there's sufficient demand," Rosenbluth said.

The Workplace Equality ETF has attracted $6.7 million in assets so far. The Barclays Women in Leadership ETN has $26 million in assets. The Pax Ellevate Global Women's Index Fund has $58 million in assets.

—By Andrew Bloomenthal, special to CNBC.com