Will socially responsible investing turn out to be like organic lettuce — yet another luxury discarded in hard times?

The Social Investment Forum claims that managers promising alpha as well as altruism have attracted a growing share of the investment pie in recent years — as much as one out of every nine professionally managed dollars in 2007. Returns improved for this category of investment earlier this decade, encouraging those people blessed with both money and a conscience to support companies and projects that they considered worthwhile. Recently, though, many socially responsible investment funds have stumbled.

For the year ended May 31, for instance, the S&P 500 lost 6.7%, while the Ariel Fund (ARGFX), one of the largest in the socially responsible investment category with $2.8 billion in assets, was down 20.2%. Meanwhile, one of the oldest SRI players, Domini Institutional Social Equity Fund (DSEFX), was off 10.6%, and the Sierra Club Stock Fund (SCFSX) was down 12.9%. The Winslow Green Growth Fund (WGGFX) is down almost 17% year-to-date.

A look at the ups and downs in the sector shows that industry weightings may influence returns more than the benevolence or ethics of management.

Amy Domini, CEO of the eponymous money management firm, suggests that the SRI group has been hit by an underweighting in international oil stocks. “International oil is an important driver. I won’t buy those shares because of environmental and human rights issues. I could buy Apache, but I’m killed by not having Exxon, for instance. All of us have underweightings in different things, but tobacco isn’t going to hurt us — it’s too small. It’s the humongous oil companies that hurt.”

Having a small exposure to oil is not the only signature SRI position. “Generally speaking, when certain sectors are running, the SRI group will lag,” a senior analyst with Morningstar, Bill Rocco, says. Although he cautions that performance will vary considerable among SRI funds, he confirms that as a group they tend to have heavier exposure to software, health care, and even financial stocks.

The widely followed KLD 400 index, a barometer for SRI investors since 1990, is off 7.8% in the past year. During the past three years, the index has also trailed the broader market, with a gain of 5.87% compared to 7.57% for the S&P 500. As investors perceive the cost of conscience to be rising, they may well abandon the sector.

Socially responsible investing comes in a variety of shapes and sizes, but there are three main strategies that the cognoscenti include under this banner. The most important is funds that screen to exclude, for instance, companies doing business in Sudan. This type of activity first came to public awareness during the 1980s, when investors successfully fought against apartheid in South Africa. Investors not only seek companies that do not engage in certain activities, but also screen for those that promote excellent employee relations or safe and environmentally friendly products.

The second category of SRI investing is shareholder advocacy, which is much in the news these days as investors weigh in on a variety of corporate governance issues, including executive compensation.

The third type of SRI is community investing, which promotes resources and opportunities for economically disadvantaged people.

According to the SIF, SRI assets increased 324% between 1995 and 2007, to $2.71 trillion from $639 billion. Over the same period, total money under management grew less than 260%, to $25.1 trillion. In the past two years, SRI assets grew 18%, compared to less than 3% for all invested funds.

The growth in the sector has created a burgeoning number of mutual funds, exchange-traded fundss, and alternative opportunities. The biggest portion of SRI money ($1.9 trillion) is managed for institutions and high-net-worth individuals in separate accounts, while $171.7 billion in net assets is held in some 173 mutual funds. In part the increase in these assets reflects growing consciousness about issues such as global warming and the crisis in Sudan. The SIF also attributes the gains to the growing number of institutional investors that are supportive of shareholder resolutions on “social, environmental, and corporate governance issues.” Practically speaking, the gains have also come from fund managers who have been quick to seize on the popularity of such investing, and who have crafted new targeted funds appealing to investors championing causes.

Perhaps as important, numerous studies have concluded that the penalty paid by investors in recent years for putting their money where their hearts are has diminished. This has not always been the case, and, based on recent figures, the penalty could be on the rise again.

Not only have SRI managers been penalized during the past year by their underweighting in oil stocks, but they tend to shy away from investments in mining companies (nasty environmental issues), gaming stocks, and defense issues, many of which have been relative winners over the past 12 months.

The Calvert Large Cap Growth fund (CLCIX) is a good case in point. The $876 million fund avoids sin stocks in gaming and tobacco and has limited exposure to companies that perform animal testing or that manufacture weaponry, instead seeking out companies that proactively promote human rights, community investment, and good labor relations.

The fund is off 14.5% year-to-date, compared to a 7.3% drop in the S&P. Although the fund has benefited over the past year from its holdings in some big tech names such as Google and Research in Motion, those names have sagged recently, as have positions in Apple and Nokia. It has also been held back by its low exposure to energy.

The reality is that the performance of these funds is skewed by their relative exposure to various industry groups. Good works today simply don’t measure up to oil prices of more than $130 a barrel. Investors may (and possibly should) choose to support firms they consider highly ethical, but they may well have to accept lower returns to do so.

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