SINVESTORS CAN REAP SMOKING-HOT RETURNS

You might expect a mutual fund that has beaten the S&P 500 by an average of nearly two
percentage points annually since 2002 to rake in billions of dollars from eager investors.

How come the USA Mutuals Barrier Fund has only $292 million?
The portfolio is allocated equally across four industries that many investors hate: tobacco,
alcohol, gambling and defense. Over the past 10 years, the fund is up an annual average of
8.3%, after expenses, compared with 7.9% for the S&P 500and just 7.2% for the Vanguard
FTSE Social Index Fund, a feel-good portfolio of socially responsible stocks.
New research indicates that a distaste for butts, booze, bets and bombs may depress prices for
such stocks in the short run, enabling sin-vestors to outperform in the long run. It also suggests
that if you seek to beat the market, you should favor whatever is most profoundly unpopular.
A study released this past week by finance researchers Elroy Dimson, Paul Marsh and Mike
Staunton of London Business School shows that over the past 115 years, U.S. tobacco stocks
returned an average of 14.6% annually, compared with 9.6% for U.S. stocks.
Since such a differential grows powerfully over long periods, $1 invested in tobacco stocks in
1900 would have grown to $6.3 million by the end of 2014; the same $1 in the broader stock
market would have grown to $38,255. Similar results have been found world-wide.
It appears that when the people who abhor such stocks have shunned them, they have
depressed the share prices but havent managed to destroy the industries, Prof. Marsh says. So
investors who dont have the same scruples have been able to pick up [these stocks] at a
cheaper price.
That doesnt surprise Gerald Sullivan, portfolio manager of the USA Mutuals Barrier Fund. Maybe
socially responsible investors feel good about what they own, he says, and so the value they
get doesnt have to come from beating the market.
Sin stocks negative aura makes attracting investors a constant battle, he says. Last year,
the fund changed its name from the Vice Fund.
Twenty years ago, Burton Morgan had the same problem. The Ohio entrepreneur had run a
private portfolio called Morgan SinShares. When he took it public, he rechristened it FunShares.
The firm that marketed FunShares changed Mr. Morgans words liquor, smoking and gambling
stocks to consumer nondurables that tend to be cyclical, says Robert Pincus, a former director
of the fund. Even so, the fund never got much above $10 million and shut down after Mr. Morgan
died in 2003.
In November 2007, the FocusShares ISE SINdex Fund launched. The assets of the exchange-
traded fund, which held tobacco, alcohol and gambling stocks (ticker symbol: PUF), peaked at
around $10 million in mid-2008. The ETF was an early casualty of the financial crisis and shut
down at the end of October 2008, says Erik Liik, former president of FocusShares.
The International Securities Exchange, an options market, maintains the SINdex, although no
fund currently tracks it.
ISE calculates values for the SINdex back to Dec. 31, 1998. (The index didnt exist then, and you
couldnt have invested in it.) The S&P 500 has returned an average of 5.2% annually since the
end of 1998, counting dividends, according to S&P Dow Jones Indices. Over the same period, the
SINdex has gained an average of 16.1% annually.
If you had been able to invest $10,000 in each index at the end of 1998, you now would have
$110,872 in the SINdex and $22,729 in the S&P 500. Even since 2007, it has beaten the S&P 500
by an average of 1.1 percentage points annually.
Sin stocks arent recession-proof, and there arent enough of them to smooth out what can be a
bumpy ride. The SINdex holds only 29 companies; the Barrier Fund, 46. When one sinful sector
does poorly, it drags down the whole portfolio. The Barrier Fund lost 41.6% in 2008 and gained
only 0.8% last year, as gambling stocks crapped out. And the fund has a 1.47% annual fee, or
$147 per $10,000 investment, so it is far more costly than an index fund that holds the broad
market.
Still, there is an investing lesson in these results of sin-vesting. For excess return to persist, the
typical investor has to hate something about the companies that produce it; otherwise, they
would never be cheap enough to offer lasting value.
The past few years, fund companies have been flogging so-called alternative or smart beta
strategies: stocks with high dividends, low fluctuations in price, high profitability, low market
valuation and so on.
All have been shown to beat the market over long periods in the past. But will they in the future?
You have to worry that some of these results are just due to chance and wont persist, or that
once theyre publicized their popularity will lead them to self-destruct, Prof. Marsh says.
But the behavioral distaste attached to sin stocks is so visceral, he says, that it seems likely to
persist.
Therefore, before you climb onto the bandwagon for an alternative strategy, ask why something
that is becoming so popular should offer a durable performance advantage.
Until investing in it feels like a sin, maybe you should wait.