Many investors around the globe are familiar with ethical funds, and even more so in the Muslim world where Islamic funds, compliant with shari’a rules are common. Among these funds are the Amana Growth Fund, which follows Islamic principles, the Pax World Growth Fund, one of the oldest of “ethical” funds, and the Ariel Fund. On the other side of the spectrum, meet vice funds, which target “sinful” industries, such as alcohol, gambling, defense and tobacco.
According to Matthew Reilly, senior stock analyst with Morningstar, the regulation by government agencies of certain sectors — gambling, alcohol and tobacco — provides them with an indirect advantage. “The interaction between regulatory bodies and industries operating in such areas, through seemingly adversarial, has become more symbiotic in practice,” he wrote in October 2007. Governments are hence relying heavily on such industries that provide them with higher returns via heavy taxation, a reason that might explain ‘vice’ stocks strong overall performance. Reilly believes that the tobacco industry remains largely attractive. The market is seen as an extremely stable oligopoly with a fairly inelastic demand curve.
“In the alcohol sector Diageo, also known as DEO, is an excellent brand as the firm is positioned in more than 180 countries in the world,” underlined Fawzi Sabbagh, senior financial consultant for capital markets at FFA Private Bank. According to Reilly’s report, the company has developed an exclusive distributor base in the Unites States, putting to use its large scale advantage. “The need for regulatory approval from governmental agencies, as well as scale advantages, combine to create wide long lasting moats in industries of questionable social benefit.”
Consequently, does vice constitute the right investment choice for any client? “If I offer you a fund that provides you with long-term capital growth, limited volatility, performance levels that vary between 17% and 18% and a yield-to-date (YTD) of 18%, what will your reaction be? The fund will be invested with 70% in American stocks, 20% in foreign stocks and 5% in bonds and targeting sectors such as information, services and manufacturing,” Sabbagh explained. “However, you will think twice, if you know that your capital will be poured into sectors such as tobacco, alcohol, defense and gambling.”
According to Laurie Roberts, president of USA Mutual funds, investment advisor to the Vice Fund, around $180 million were invested in the fund as of January 31, 2008. She believes that the good performance of the four sectors, namely alcohol, gaming, tobacco and aerospace or defense resides in the steady demand for such products. “These particular sectors are global in nature as people smoke, drink and gamble, while countries around the world defend themselves,” she said.
All of these sectors demonstrate one or more key attributes steering them away from dour returns, mainly a stable demand regardless of economic conditions, potentially high profit margins, a global marketplace dovetailed with natural barriers to new competition such as in the case of the highly regulated tobacco industry. “Global demand within these sectors typically results in low correlation to the U.S. economy. Strong pricing power and low cost of production tend to make the tobacco and alcoholic beverages sectors very profitable,” explained Roberts.
According to the Vice Fund website, specific industries namely alcohol, tobacco, defense and gambling exhibit defensive qualities. “Consumer staples like tobacco and beverages are widely considered to be defensive, because they are generally thought to be uncorrelated with moves in the broad equity market,” it said. The aerospace and defense sector, too, are more directly tied to budgetary cycles than fluctuations in the economy and the stocks of defense contractors are not directly linked to fluctuations in the broader market. The study also estimated that defense stocks had had almost no correlation with the S&P 500 over the last twenty years. “In the defense sector, the outcome of the American presidential elections is essential, as each party views defense spending and taxation very differently,” said Fawaz.
The report issued by the Vice Fund also indicated that there was little correlation between the tobacco sector and the equity market, namely the S&P500. “In light of the recent market hysteria, UBS put out a note last week looking at how the tobacco sector has fared in periods of high volatility. According to UBS, there have been 1,336 days since 1997 when the CBOE Volatility Index, or VIX, an index that measures volatility, has closed above 20; over those days, tobacco stocks gained 12.5%, while the S&P 500 declined 39.2%,”pointed out the report which was published last August.
Regardless of the economic situation, funds that target sectors such as alcohol, gambling, tobacco and defense have show positive returns in spite of adverse market conditions, underscored Fawaz. The Vice Fund achieved strong results in 2007, with the fund up 17.76%. The Fund, a five-Star Overall Morningstar rated fund, among 1,623 large blend funds, had a cumulative return since inception in 2002 of 142.35 % as of the end of 2007. The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three- and five- Morningstar Ratings metrics.
The consultant believes, however, that such funds might pose a moral dilemma for many investors, especially Arab ones. Regardless of the ethical issues at stake, businesses seem to be looking the other way, as profit margins and growth remain the main elements to be put under scrutiny. The recent partnership between Dubai and MGM Mirage, worth $5 billion and aimed at developing casinos, is a perfect illustration of such a trend, despite the official Emirati ban on gambling.
