Fund name: Parnassus Small-Cap (PARSX)

Objective: the fund seeks long-term capital appreciation by investing primarily in domestic small cap stocks. The threshold for small caps is $3 billion at the time of purchase. The securities first go through the firm’s social screens, which assess both positive attributes (ethical business practices, fair hiring, community engagement and so on) and negative ones (involvement in alcohol or tobacco). "These companies must, in the Adviser’s opinion, be undervalued, but they must also have good prospects for long-term growth and an identifiable catalyst that could move the stock higher in the succeeding 12 months." The fund holds about 30 stocks.

Adviser: Parnassus Financial Advisors. Parnassus is a San Francisco based boutique investment management firm with over $1 billion in assets under management. They manage five mutual funds as well as money for institutional investors. They’re "socially responsible investors" (SRI) which, in their case, means they "look to invest in companies that are good workplaces, have sound environmental policies, have a record of civic commitment and follow ethical business practices. At the same time, we also screen out companies that manufacture tobacco or alcohol products, are involved with gambling, are weapons contractors or generate electricity from nuclear power." Parnassus claims to be "one of the few" SRI firms that does its own social and financial research.

Managers: Jerome L. Dodson. Mr. Dodson is Parnassus’s Chairman and CEO. He also manages the Parnassus fund, Parnassus Mid-Cap and Parnassus Workplace (which invests in companies that treat their workers well). He founded Parnassus in 1984 and is very active in community organizations in the San Francisco Bay Area.

Management’s Stake in the Fund: he has somewhere between $100,000 and $500,000 in the fund and has well more than a million invested in the funds he manages.

Inception: April 29, 2005.

Minimum investment: $2000 for regular accounts, $500 for IRAs.

Expense ratio: 1.40% on assets of $10 million.

Comments: skepticism runs high about the financial wisdom of investing in "socially responsible" funds. The argument is straightforward: it’s hard enough to find good ideas without arbitrarily eliminating half of them because of some arbitrary set of do’s and don’ts unrelated to their stock value.

SRI advocates respond by arguing that bad corporate behavior is, in the long term, bad for business. Bad actors and unsafe products lead to lawsuits, negative publicity, and government regulation. Even if the economic cost of such consequences were limited, they serve to distract management and encourage competitors.

Are they right? There is some decent research moving in that direction. At the very least, SRI screens do not decrease returns. When folks look at matched indexes which differ only because one is socially screened, the effect of the screen is zero. In a 1997 study by the quant guys at Vantage Global Advisers found that an unscreened large cap portfolio returned 1.068% per month over 13 years while a screened portfolio returned 1.057% per month. From this they concluded: "There is no statistically significant difference in the respective return series. More importantly, there is no economically meaningful difference between the return differential." Ten years later, research by SEI reached an identical conclusion: any negative effect was almost immeasurably small (SEI Investments, "Socially Responsible Investing and Active Management," January 2005). A review of several dozen studies led to the same conclusion: SRI indexes mostly outperform the market, SRI funds might have a competitive advantage but it’s awfully small, and there’s no evidence of a systematic disadvantage to using SRI screens (Phillips, Hager & North Investment Management, "Does Socially Responsible Investing Hurt Investment Returns?" 2007).

So here’s the bottom line: (1) there’s no trade-off between your wish to "do good" and your desire to "do well" and (2) if you find a talented manager, don’t be concerned if she’s using SRI screens.

And, as it turns out, it looks like Mr. Dodson might be a talented manager. Even after the Black Monday bloodbath, the fund was in the black for 2008. Which might be a fluke. The fact that it’s in the top 1-3% of small cap funds for most trailing periods is less flukey. And the fact that it has earned five stars from Morningstar and a "Lipper Leaders" designation for total return, consistent return, and tax efficiency is even better. Finally the fact that all four of Mr. Dodson’s funds earn one of Lipper’s two highest "total return" rankings (4 or 5 on a scale where 5’s are the Lipper Leaders") and that three of his four funds earns four- or five-stars from Morningstar strengthens the case.

What might be contributing to Mr. Dodson’s success? Four factors appear to be most important. First, he’s made such prescient sector calls. His fund has very limited exposure to financials and a lot of exposure to utilities. Second, he’s pretty careful about compensating for the intrinsic riskiness of small cap by investing only in "wide moat" companies. Dodson writes, "One factor that helped performance is a focus on companies that have unique characteristics. This doesn’t mean they don’t have competition; it does mean they have expertise in a specific area that helps them weather economic storms in bad times and do very well in good times" (Annual Report, June 2008). Third, he has no direct exposure to international markets which has been a boon this year. Finally, his risk consciousness led him to keep a lot of the portfolio in cash – almost 20% at latest report.

There’s also the episodic gains triggered by buy-outs, where small companies get snapped up by private investors. By way of example, PARSX got a 47% premium for Bright Horizon Family Solutions stock earlier this year when the company was bought by Bain Capital.

Bottom line: This is a small niche. Of the 100 socially responsible retail mutual funds, only four tiny funds (they have under $50 million between them) target small cap stocks. Those are Ave Maria Opportunity (AVESX), Pax World Small Cap (PXSCX), LKCM Aquinas Small Cap (AQBLX) and Parnassus. Both Ave Maria and LKCM derive their social screens from Catholic dogma. With relatively low expenses, a compact portfolio and an experienced manager, folks who would like to invest in small companies while being confident that they’re not simultaneously investing in b*st*rds might find a lot to like here.