Ethical investment can be a risky business

ETHICAL investing is not a new concept. But while, in the 1960s, it was led by the Methodist Church’s decision to avoid stocks in sectors such as alcohol and gambling, nowadays issues such as climate change are the main drivers. As of 30 June 2012, there was approximately £11bn invested in Britain’s green and ethical retail funds.

Each ethical fund tends to use different screening criteria and has its own definition of what constitutes “ethical”, making it tough to define. Many funds are classified under the umbrella term “ethical investing”, but the strategies they follow will vary greatly (environmental funds, socially responsible funds, and so on).

To cater for different preferences, funds are categorised by providers from dark to light green, encompassing a variety of criteria. Dark green funds will tend to exclude companies that derive turnover from industries such as tobacco, alcohol, or pornography. Lighter green funds have limited exclusion criteria, so may focus on environmental friendliness, for example, but not other issues. These funds may define themselves as ethical, but it’s unlikely they would get investment from a 1960s Methodist churchgoer.

There is a long-running debate on their financial performance. By only investing in ethical funds, investors are limiting their ability to diversify. So, purely from an investment point of view, this is “not the optimum approach”, says Laith Khalaf, analyst at Hargreaves Lansdown. Ethical investing also tends to give investors a bias towards small and medium size companies, which often makes performance more volatile.

Darker green funds tend to have very limited exposure to oil, gas, and commodities companies, which account for a large part of the FTSE All Share Index (oil and gas companies alone make up 17.05 per cent of the Index). If these funds opt to exclude tobacco companies as well, their investment opportunities get even narrower.

According to data from Morningstar, the average ethical fund in the UK All Companies sector returned 12.68 per cent year to date (to 31st October 2012), versus 4.6 per cent for the ethical benchmark, the FTSE4Good UK 50 index. Over the same period, non-ethical funds in the same sector returned 12.44 per cent while the FTSE All Share Index achieved a 9.3 per cent return. Over one and three years, ethical funds on average outperformed their ethical benchmark whilst keeping in line with their Investment Management Association (IMA) peers.

A look at the longer-term performance of ethical funds in the UK All Companies sector versus the FTSE All Share over five years shows that four of these funds met or beat the Index. However, nine under-performed – by as much as 21 per cent. Jason Hollands of Bestinvest attributes this to “a torrid period for markets, compounded by the fact that these funds aren’t able to access some of the defensive industries, such as tobacco, that have held up well”. Indeed, tobacco has delivered stellar returns these last five years, with British American Tobacco up 130 per cent.

But if ethical considerations are your primary driver, some funds are strong contenders. Kames Ethical Equity, a dark green fund, has a restricted investment universe but has outperformed the market by 3.6 per cent over the past five years, according to TrustNet. According to Khalaf, the Jupiter Ecology Fund has “outperformed the IMA by roughly 20 per cent”.

When considering ethical investments, Morningstar analyst Karine Glauser advises that investors ensure they are “aware of the underlying risks involved in this type of investments. As any investment, it should be considered over the medium to long term (five years minimum) and keeping in mind the potential added volatility that comes with this type of fund”. And as with any other investment, it is also important to consider the fund manager’s experience and process.

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