Ethical investing: The principles or profits trade-off

Annabel Palmer on the risks involved in adopting “socially responsible” strategies

WE ARE now mid-way through this year’s National Ethical Investment Week – designed to inform the public that they have “sustainable and ethical options” in their financial decisions. In recent years, low opportunity cost – driven by low interest rates and the struggle to get capital growth on savings – has led some investors to consider these options, especially those previously of the view that ethical investing involved a “principles versus profit” trade-off.

So are investors truly starting to prioritise a company’s ethical credentials before making an investment, just as shoppers check their tea is Fairtrade before reaching the till? Research from the Investment Management Association suggests not. It found that their share of total funds under management was just 1.2 per cent (or £8.6bn) – the same as this time last year.

But while ethical investing is not a new concept, each fund tends to use different screening criteria and has its own definition of what constitutes “ethical,” making it hard to pin down. Since Friends Providence launched its first stewardship product in 1984, the term has grown to cover a range of themes, from socially responsible investment (SRI), to environment or governance investing. To keep things simple, providers divide the funds into three categories: dark, medium, and light green.

Dark green funds have the strictest ethical restrictions, and tend to have very limited exposure to oil, gas, and commodities companies – which account for a large part of the FTSE All Share Index. As such, Adrian Lowcock of Hargreaves Lansdown warns that the performance of these funds can be limited by their exclusion criteria. Having no exposure to defensive sectors like tobacco – which has delivered 26 per cent returns over five years – means investors are limiting their ability to diversify.

In addition, they can give investors a bias towards small and medium-sized companies, making performance more volatile. Medium green funds, meanwhile, apply strict criteria, but allow exposure to oil, banks and pharmaceuticals. Light green funds still limit diversification, but do reflect the sectors of the conventional equity market and focus on large-cap companies.

Despite these restrictions, SRI advocates suggest that, in the long run, ethical investment should be profitable. Simon Howard of the UK Sustainable Investment and Finance Association asserts that “irresponsible” firms will suffer financial consequences. “For example, it is unethical to pollute, but it’s also bad business. Companies that do pollute may find it harder to get permission to open new sites,” he says.

And even if ethical considerations are not your main driver, some funds are offering good returns. Indeed, in August this year, Moneyfacts claimed that the average ethical fund was up 36 per cent, compared with 31 per cent for the average non-ethical fund over three years. And while the IMA UK All Companies benchmark has seen 71 per cent returns over a five year period, Standard Life UK Ethical, for example, saw 96 per cent.

Lowcock rates the Kames Ethical Equity fund. It is categorised as dark green, but by maintaining exposure to domestic-facing companies, it has returned 182 per cent over the last 10 years, beating the FTSE All Share (which returned 127 per cent).

Those who do decide to go down this route need to decide what their key issues of concern are, and then “select a fund with a set of policies that most closely match their criteria,” says Jason Hollands of Bestinvest. The rules for selecting a good ethical fund are the same as for any investment: do your research to guarantee an informed decision, and carry out a rigorous assessment of the fund manager’s experience and methods.