Ethical investing: a pretty picture

While they"re not in the public eye as much as they were years ago, ethical funds have quietly grown in size and stature. David Burrows looks at how they can be a solid investment choice

Prior to the global financial crisis, ethical and socially responsible investing (SRI) funds seemed to be very much in vogue, with investors able to make "moral" decisions around their investments. But did the heavy losses endured after the crisis persuade many investors to jettison principles in favour of bottom-line returns?

Without doubt there was an initial reaction from investors - total funds under management in ethical funds did drop significantly from £8.8bn in December 2007 to £6.79bn in December 2008. However, in their defence, most stock market investments saw outflows of money post-financial crisis. What is encouraging is that money has returned to these funds since then.

What is also interesting is how quickly the money started to come back. The stock market hit bottom in March 2009 and yet at the end of that year, money in ethical funds rose to £9.52bn. Not all ethical funds exclude banks, so it"s a little presumptuous to say the increase was due to negative sentiment towards one shamed sector, but it may have been a factor.

As Stephen Hine, Head of Responsible Investment Development at EIRIS (a research specialist in responsible investing), says: “Funds take different stances on banks, so there won"t be a clear-cut answer, however I would say that investors in ethical and sustainable funds tend to be more "sticky" - even in bad times.”

Philip Radford, Director at Saffrey Champness, Guernsey, takes a similar line. “Ethical or SRI funds don"t suit and aren"t desirable for everybody, but those that had a strong conviction to invest in this way before the financial turmoil generally held on to that conviction during and after that period,” he says.

In no sense, then, have ethical funds fallen by the wayside. EIRIS shows that as of 30 June 2013 - the latest period for when their figures were available - there was approximately £12.2bn invested in Britain"s green and ethical retail funds. To put this in context, 10 years previously this figure was only £3.57bn. So the general trend in investment levels is upward and there is a broader choice too, with around 80 UK domiciled green and ethical retail funds available.

Cleaning up

At the moment the media spotlight appears to be on cleantech funds - and it"s easy to see why clean energy might appeal to an investor. The initial capital investment requirement and subsequent income flow and maintenance costs are all very predictable and easy to understand. However cleantech, like all types of funds loosely falling under the "ethical", "green", "SRI" or "sustainability" label, faces the common criticism that they are too narrow in their focus, and that by being niche they lack real investment appeal.

Peter Miller, Executive Director at E&Y, Channel Islands, insists cleantech shouldn"t be seen as a narrow field, but one that offers good potential. “In essence, people tend to see cleantech as solar, wind, hydroelectric energy solutions, but it"s much broader than that. It also includes sustainable smart grid solutions - looking at ways to reduce the energy you use. Cleantech funds could even include oil and gas companies that are looking at ways to reduce pollution levels and increase energy efficiency.”

Miller adds that some cleantech funds may not even follow an ethical investment strategy at all - certainly for some investors, any investment in the oil and gas sector would be unpalatable.

In fact what becomes clearly apparent in the world of ethical investing is that you are seldom comparing like with like. SRI, ethical, cleantech and climate change funds all differ in their investment boundaries - for example, oil companies may be "no go" for one fund but not another.

Typically, ethical funds will screen out sectors entirely, while SRI funds are more focused on improving practices of the companies they invest in. Either way, the definitions and distinctions between funds are not always easy to fathom (see page 88).

It"s down to the individual investor or their financial adviser to drill down and see how far a fund"s investment criteria fit with an individual"s ethical stance and tolerance for risk. For instance, one investor"s priority may be to boycott tobacco and alcohol companies while another may feel strongly about genetic engineering, intensive farming, animal testing, the fur trade, fossil fuels or gambling.

Responsibility vs return

So, because ethical funds are restrictive in nature, do investors have to be realistic about expected returns and understand there is usually a trade-off for sticking to a moral stance? To some degree yes, as Philip Radford explains: “Generally speaking, if you wish to achieve a "greater good" with your money, the reality is that clearly you have to give up some performance.”

The general rule of thumb is that stricter funds are prone to suffer more, while those that are more liberal in where they can invest typically fare better. As Radford points out: “Those funds that have investment criteria excluding large parts of the market will almost certainly be more volatile and higher risk, although a really good manager can overcome these innate attributes and provide good consistent performance.”

His views are echoed by Miller, who points out the success of an ethical fund like many others depends on the stock-picking skills of the manager. After all, it"s not just ethical funds that are restrictive - technology funds, Asia Pacific funds, smaller companies funds and gold funds are, by their definition, limited in where they can invest, though this doesn"t stop people investing in them and making money. You could even argue that exclusions on ethical grounds could actually be an advantage if it means you avoid companies constantly embroiled in lawsuits or in industries that are vulnerable to the introduction of new, environmentally cleaner technology.

For some ethical funds, there would appear to be little trade-off between investment restrictions and the returns they are able to generate. For instance, the Premier Ethical fund is currently ranked 10th over one year in a hugely competitive UK All Companies sector of 264 funds - most of which have no ethical exclusions. Similarly the Standard Life UK Ethical is ranked 33rd over three years in the same sector - so ethical funds, if managed well, can more than hold their own.

As Andrew Mason, SRI Analyst at Standard Life Investments points out, ethical funds can offer good returns and still provide well-diversified investment. “The Standard Life UK Ethical fund has 51 per cent exposure to the FTSE All Share Index after we have applied our ethical screening. So there is still a big universe of stocks to choose from across a well-diversified number of sectors.”

And as Mason is quick to state, responsible investing is as much about engagement as it is about simply screening out sectors. “Collaborative engagement is important. We regularly meet the companies in which we invest, focusing on environmental and social issues. It"s more than us just asking 50 questions and ticking boxes, we want to see the outcomes from their actions.”

As a significant investor in a company, an ethical fund manager is in a position to challenge senior management and exert a positive influence on policy. By working with companies, and in some cases regulators and politicians, they can also help develop best practice standards and improve corporate responsibility.

Mason stresses that by working with companies in this way, operations often improve, which is of benefit to both the corporates themselves and to those who have invested in the fund. Companies that pay consideration to social and environmental issues are often better managed, less liable to litigation and more profitable than those that don"t.