How to Invest in Sin Stocks

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There have always been ways to invest in sin stocks, but the notion of making a category out of companies that sell products like cigarettes, beer, guns, and weed came about in part from the rise of socially responsible investing. While socially responsible investors largely avoid sin stocks, the strong returns that the businesses in these categories have given their shareholders have made them attractive to many investors.

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To invest in sin stocks, you have to answer a few basic questions:

  • Do you prefer any one category of sin stocks to others?
  • How much diversification do you want in your sin stocks?
  • Do you want to invest in individual stocks or through funds?

A broad range of sin stocks

Just because you like the idea of investing in sin stocks doesn't mean that you necessarily like the prospects for all of them. As an example, the tobacco industry has been in a longtime secular decline for decades, with the number of smokers in the U.S. falling dramatically. Companies have been able to ratchet up prices during that period in order to sustain revenue and profits, but some fear that there's a limit to how high prices can go before they reach a maximum. Similarly, gun stocks did well under political conditions that created a high likelihood of gun control regulation. Yet with a friendlier political environment, firearms manufacturers have suffered from lower demand for their products.

Prospects for some sin-stock categories look more promising. Alcohol has been a growth industry in many niches, ranging from craft beer to micro-distilleries of spirits. The casino gambling industry has rebounded from tough times in the Asian gaming capital of Macau, rewarding investors who stuck it out through tough times. And in marijuana, up-and-coming producers are taking advantage of legalization in a handful of states across the country.

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Which categories you choose is a matter of personal preference. But the more you want to focus on any one area, the more you'll want to consider whether your potential returns justify the risks involved.

Getting diversified

Once you choose one or more sin-stock sectors, the next question is whether you want to own a diversified portfolio of such stocks or drill down on just a couple of top performers. The benefit of diversification is that you'll typically enjoy any uptick from generally favorable trends for the industry at large, and you won't be as vulnerable to any one company's mistakes having a downward impact on that particular stock. Yet the downside of diversification is that you miss out on the chance to pick true winners in their field.

How much you should diversify depends on how many industries you choose and how confident you are that you can identify the standout leaders of those industries. In general, the fewer industries you focus on, the more assured you need to be in order to take a concentrated position in just a couple of stocks in each industry.

Looking for sin funds

Historically, it's been easiest to invest in sin stocks directly through individual brokerage accounts. However, investors who prefer mutual funds and exchange-traded funds have a couple of options to invest.

The USA Mutuals Vice Fund (NASDAQMUTFUND: VICEX) has put up extremely strong performance over the long run. Its nearly 11.5% average annual return over the past 15 years puts it among the top 3% of mutual funds classified as large-cap blend funds by Morningstar. More recent returns over the past year and three years have been similarly impressive compared to its fund peers. Among its top 10 holdings, you'll find three tobacco companies, four casino resort operators, two beer and spirits companies, and a defense contractor that manufactures weapons systems for the military. The downside of the fund is its hefty expense ratio of 1.49% per year, although its returns have more than made up for that big headwind since its inception in 2001.

Just this month, ETF investors got a similar option for investing. AdvisorShares Vice (NASDAQ: ACT) has roughly 50% exposure to alcohol stocks, with 30% invested in tobacco and 20% invested in stocks related to cannabis. With a 0.75% expense ratio, the ETF is cheaper than its mutual fund peer, but it's still fairly high compared to other ETFs. The fund's strategy involves taking advantage of established growth trends in alcohol and tobacco while using cannabis as a growth opportunity to provide further upside.

Should you own sin stocks?

Sin stocks aren't for everyone, but their returns historically have made them worth their while for many investors. By following this three-step thought process, you can make an informed decision about whether to include sin stocks in your investing.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.