Rules of Disengagement

What’s valued at more than $231 billion? Answer: the assets of some 3.8 million current and former federal employees, everyone from letter carriers to U.S. Senators, whose retirement funds are socked away in the Thrift Savings Plan (TSP), one of the largest and fastest-growing 401(k)-style funds in the U.S. If Senator Joseph Lieberman of Connecticut has his way, the TSP will soon radically alter the way it picks some of its stocks. Lieberman told TIME he will introduce legislation to give all TSP participants the option to disinvest in companies that do business in or with countries labeled by the U.S. as state sponsors of terrorism. That list currently includes Iran, North Korea, Syria and Sudan. “Terrorism is the greatest challenge to our security today, and the Federal Government is working night and day to prevent and prepare for it here at home and to combat it overseas,” Lieberman told TIME. “Federal employees should be given the opportunity to opt out of investing in companies that do business with state sponsors of terrorism, and the companies themselves must understand that there is a price to pay.”

Lieberman’s initiative will add momentum to an antiterrorism bandwagon that has already started to roll. Last month, FTSE, a big provider of indexes, and the Conflict Securities Advisory Group (CSAG), a research consultant, launched a “terror free” index that excludes assets for some 400 foreign firms that operate in terrorism-supporting countries. Northern Trust, a huge fund manager that caters to both individuals and institutions, will soon roll out investment products based on that index. A source familiar with the naughty list says both ABB, a Swiss engineering giant that does business in Iran, and the China National Petroleum Corp., which operates in Sudan, are included.

The tool is not limited to multibillion-dollar funds: CSAG is also offering a free service called the Terror-Free Calculator (https://www.terrorfreecalculator.com) Very few U.S. mutual funds have so far embraced terror-free investing. But as it expands, this device will let anyone evaluate his own mutual funds. Parametric, another big asset manager, last month produced a terror-free screen of stocks that is available through intermediaries including Smith Barney, Merrill Lynch and Bank of America. Credit Suisse has also released a new terror-free product.

Predictably, all three presidential candidates have endorsed the terror-free concept. In California, Governor Arnold Schwarzenegger recently signed a measure terminating investment by the state’s huge pension funds CalPERS and CalSTERS in companies doing business in Iran. At least 19 states, including New York, New Jersey, Texas, Pennsylvania, Maryland, Missouri and Louisiana, have proposed or passed laws requiring state pension-plan sponsors to divest from firms with business links to terrorism-sponsoring nations.

Companies in Europe, in Asia and elsewhere face no such restrictions. Many, like France’s energy behemoth Total or Russia’s Lukoil, are only too happy to sidestep American competitors as they pursue business in nations like Iran, which badly needs outside help for its oil industry. If the terror-free trend should spread, those companies could face significant divestment by U.S. shareholders. Other big-name international companies that have done business with outlaw states include Siemens, Hyundai, Alcatel, BNP Paribas and Statoil. The roster of some 400 global companies excluded by the FTSE/CSAG index includes many that trade on U.S. stock exchanges.

Almost no U.S. companies trade directly with rogue states because federal law forbids commerce with countries found to be state sponsors of terrorism. In the past, foreign subsidiaries of General Electric, Halliburton, Aon and Foster Wheeler have all done so legally. But these companies were approached several years ago by folks like New York City pension authorities and agreed to terminate or eventually end their involvement.

What happens if U.S. products get transshipped to terrorism-supporting countries–say, if Pepsi or Kleenexes or Marlboros end up in Tehran? Nothing. The screening focuses solely on big transactions, usually with signed public contracts that are disclosable by publicly held companies; black-market materials, transshipments and the like are not in the mix.

The proposed legislation comes at a tough time for investors because with the dollar sagging, experts recommend a slug of foreign stocks and bonds for a diversified portfolio. Critics, including some U.S. fund managers, claim that terror-free investing will mean missed opportunities. And forced divestment could have tax and transaction costs that could depress a fund’s performance. According to a study by the Center for Retirement Research at Boston College, if some of the Iran-divestment bills currently before state legislatures “are passed in their broadest form, institutions may be forced to sell $18 billion in investments.” Tennessee and Maine lawmakers have rejected terror-free-investment bills, expressing concern that state retirees might suffer lower returns if the provisions passed.

Proponents insist the performance of terror-free funds will not be a problem. New York City comptroller Bill Thompson, who oversees pension funds totaling $110 billion, says there is “strong interest” in establishing a terror-free pension option for the city’s municipal workforce. He says according to the portfolio studies, the performance of terror-free funds will be as good as or better than alternatives. “Whenever you remove companies from the mix, there will be an impact,” says Stephen Schoenfeld, Northern Trust’s chief investment officer. “But when you use a very broad index like the FTSE/CSAG and remove comparatively few companies, performance is not going to change much over the long term.”

Considering that “socially responsible” and “green” funds have prospered in recent years by avoiding companies that sell tobacco or pollute, the surprise since 9/11 is that more money has not flowed into terror-free investing. Advocates argue it is a nonviolent way for Americans to confront terrorism and maybe even profit from the fight.