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Navigating the maze of ethical investments is no easy task

It’s that time of year when the ethical investment industry seeks to raise public awareness of the ability to invest in a socially responsible manner through its National Ethical Investment Week (13-19 October) campaign. Yet despite the growth in recent years of areas such ethical consumerism and eco-tourism, the data suggests ethical investment has failed to make a decisive break through into the mainstream. According to figures from the Investment Management Association (IMA), funds under management for ethical funds were £8.6 billion at the end of August 2013 and their share of total funds under management was just 1.2%, the same as this time last year.

Jason Hollands Jason Hollands
08 October 2013

All too often discussion of ethical investing seems to revolve solely around the question as to whether investing ethically will result in lower returns. However, that misses the point:  some investors have a sincerely held desire not to have their money invested in businesses like tobacco or those companies which test their products on animals irrespective of the returns those areas may offer. Ethical investing exists to provide these savers with a choice.

The trouble is that nothing is straightforward with ethical investment. It is an umbrella term for a smorgasbord of strategies and involves an inherent degree of subjectivity. In fact, the industry can’t even settle on a name for it. Over the last two decades the ethical investment industry has variously badged itself as SRI (Socially Responsible Investment), ESG (Environmental, Social & Governance) investing, SEE (Social, Environmental & Ethical) investing, Sustainable Investing and latterly Responsible Investing.

The range of funds on offer include traditional ethically screened funds, which encompass a multitude of concerns and filter out “sin” sectors (tobacco, alcohol, arms, gambling and pornography) as well as individual stocks that are evaluated as unacceptable; funds focused on identifying companies that are ‘best of breed’ for corporate responsibility across a range of industries (which in the case of the Premier Ethical fund extends to a 3% holding in pub operator Mitchell & Butlers); funds which emphasise ‘engagement’ with companies on social, environmental and corporate governance issues, and; environmentally-friendly thematic funds and niche products focused on alternative energy stocks.

While it is common to categorise funds under broad banners such as “light green”, “mid green” and “dark green” these are inadequate in conveying the important differences and nuances between funds.  Potential investors need to decide what the key issues of concern to them are - in particular whether they want a broad based ethical approach or a more narrow focus on the environment - and then select a fund with a set of policies that most closely matches their concerns.

We would argue however that beyond a few sectors such as tobacco and gambling most companies that ethical funds invest in do not neatly fit into a black and white definition of ethical or unethical but sit somewhere in between. Perhaps contrary to the expectations of some, ethical funds invariably hold large mainstream companies such as Vodafone, Royal Dutch Shell, HSBC, Lloyds Bank and GlaxoSmithKline.  The universe of stocks open to ethical funds are chosen on the basis of an often  finely balanced evaluation, a role performed in some cases by a separate committee tasked with reviewing and developing policy. For example, in the case of the oldest UK ethical funds, the Stewardship range, their committee was chaired by The Right Reverend Justin Welby, up until his recent appointment as Archbishop of Canterbury. Other funds periodically survey their investors to elicit their views. In many cases policies are not set in stone but will evolve over time so it may be necessary to periodically check whether the fund still meets your red-line criteria. Ethical funds are therefore unlikely to please all of their investors, all of the time.

It is also important to be aware that ethical funds will perform differently from conventional funds, as they will generally have a lower weighting to commodities than the broader market as well as defensive sectors such as tobacco and drinks. This means they have a higher tracking error. Over the last five years we found the average ranking of UK equity ethical funds was 56th percentile but with a generally broad dispersion between the best performers, such as Standard Life UK Ethical, which returned 96% and the worst, Scottish Widows Ethical, which delivered a 25% return. This suggests that while it is undoubtedly a challenge to deliver out performance with a more restricted universe, underperformance isn’t inevitable either. Manager selection is key.

Bestinvest’s Guide to Ethical and Green investing is available here

Current or historical yields quoted should not be considered reliable indications of future returns. The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.

Due to their nature, specialist funds can be subject to specific sector risks. Investors should ensure they read all relevant information in order to understand the nature of such investments and the specific risks involved. Please note that ethical funds may, by definition, have a limited investment universe; this may affect performance.