August 2008

Ethical dilemma

When formulating investment strategies for clients a topic that has become more prevalent in recent years is ethical or socially responsible investment. Generally these are funds which aim to avoid companies involved in activities believed to be harmful, such as tobacco production or child labour. Alternatively they can be funds which aim to actively invest in companies which promote ethical policies such as recycling.

It is worth noting that the Co-operative Bank's annual Ethical Consumerism Report, published in November 2007, revealed that in the UK last year, on average, every household in the UK spent £664 in line with their ethical values compared with just £366 in 2002, an increase of 81%.

In addition, according to the Investment Management Association, ethical funds under management at the end of Q1 2008 stood at £5.4 billion, an increase of 285% from the end of 1998. Gross retail sales of ethical funds in 1998 were £172.5m while in 2007 they stood at £880.2m and there was an increase from 24 ethical or socially responsible funds available in 1998 to 53 at the end of March 2008.

All of this confirms that ethical issues are an area experiencing significant growth.

History of ethical investing

Dating back to the nineteenth century, the roots of ethical investment can be found among religious movements including the Quakers and Methodists, whose concerns included issues such as fair employment conditions and temperance. At the beginning of the 1900s, the Methodist Church began investing in the stock market, consciously avoiding companies involved in alcohol and gambling.

In the UK an important development was an amendment to the 1995 Pensions Act that came into force in 2000. As a result the trustees of occupational and local government pension schemes have to state their policy on socially responsible investment in their Statement of Investment Principles. Pension funds control more than a third of the shares in the UK stock market and of course this gives these funds considerable influence. The impact of this legislation has been that it has raised awareness of ethical investment among trustees as well as pension scheme members who may, on being informed that their pension does not have an ethical policy, lobby trustees for a change.

Which fund to choose?

When considering which particular ethical investment to invest in it is important to understand that no two ethical funds take exactly the same ethical standpoint. Some concentrate on selecting companies according to positive criteria such as environmental initiatives, while others use negative criteria such as military involvement to identify companies in which they will not invest. A third type of ethical investment tries to balance the two approaches, while others add a further dimension – direct engagement with companies in an attempt to improve their ethical performance. Indeed these strategies may also be used in combination as well as on their own.

With all of these differing investment criteria and limitations it is perhaps not as easy as it first appears to select an appropriate ethical fund or range of funds to invest in. There is, however, a free website which will assist in this - www.ethicalscreening.co.uk You will have to register for the site but they have a very useful screening tool to aid the fund selection process.

Drawbacks of taking an ethical stance

The obvious drawback in terms of ethical investing is that by cutting down the 'pool' of investments from which a manager can select his or her stocks you are potentially limiting performance. Also ethical funds generally tend to have a bias to small and mid capitalisation stocks, which have been hit heavily in the market correction accompanying the credit crunch. This has meant that recent performance of ethical funds has generally not been good. Ethical funds have also suffered because any positive recent stock market returns have been enjoyed largely by sectors such as oil, mining and gas – areas that many ethical and sustainable funds exclude because they fail to meet environmental criteria or they operate in countries governed by regimes with questionable human rights records.

Investing in ethical funds must however be considered over the course of an economic cycle – indeed if we look at some historical numbers, it is interesting to note that of the 324 unit trusts in the UK All Companies sector for the 12 months to 31 January 2007 the Co-operative Insurance Sustainable Leaders Trust was the best performing fund in that sector.

It is also important to remember that when it comes to assessing the ethical performance of a company or an ethical fund there is no such thing as a 'perfect' company. All are involved in activities which someone somewhere will object to; none go far enough in terms of positive social contribution to satisfy all of the people all the time. Ethical investment is ultimately about compromising and prioritising.

Ethical and socially responsible investment has its merits but it also has its drawbacks and it is important that investors are aware of both. There are certainly investors for whom this type of investment is a priority or for others represents a 'nice to have' and as a result we are seeing significant growth in this area.

Andrew Gadd
Head of Research
The Lighthouse Group