Yet again, many pundits are saying that ‘green’ stocks will boom in the next 12 months, as soaring energy costs and a growing comprehension of global warming have created a climate for socially responsible investment.

However, notwithstanding the nanny state in full swing and gaining ground, are tobacco companies, sweet and cake manufacturers, fast-food joints and pubs the kind of companies we should be buying shares in, confident in the knowledge that there will always be a section of adults that never heed advice?

A narrowed field

The one thing that’s obvious about ethical investing, even to those thus far in the dark about it, is that it narrows your fund manager’s field of available options. Any ethical manager will have an extra set of constraints on top of the usual restrictions applying to his or her sector, geographical, income or growth etc. From within those restrictions the manager will have to pick stocks that comply with a further set of restrictions: those that constitute whether the pick is ethical or not.

For some ethical managers this field is smaller than others. The strict ethical fund manager adheres to a more rigorous set of criteria that rules out all oppressive political regimes and all companies that experiment on animals or pollute the environment, for example. His non-ethical counterpart will have no such qualms.

How ethical funds perform

However, ethical managers argue that they can still outperform. “The bottom line with our ethical funds is we do make money for investors,” comments Andrew

Preston, head of socially responsible investing (SRI) at Aberdeen Investment Managers. “Over the last year, for example, we’ve outperformed our benchmark, the FTSE World index.”

According to the factsheet for the Aberdeen Ethical World fund, the fund made 31.5 per cent as against 26.6 per cent for the benchmark index. Now in anyone’s book returns of over 30 per cent in one year can’t be bad; but, of course, it’s all relative. Aberdeen’s non-ethical fund in the sector, Aberdeen World Equity, made very similar returns to the ethical product, but there has been better money to be made in the last year from global growth. Whilst both Aberdeen funds are top-quartile, the leaders of the sector, funds from Neptune and First State, achieved returns more around the 60 per cent mark.

Over a longer time period, the returns from Aberdeen Ethical World drop off, (as do those from many other funds, last year having been a good one). According to Meera Patel, investment manager at Hargreaves Lansdown, ethical investors must be ready for the long term. “It’s been a good period recently for ethical funds but, three years ago, if you looked at them they were bottom of the pack,” she observes. “You can make money on them, but people who are interested in these have to be prepared for more than a couple of years’ underperformance.”

However, these days the range of funds available in the ethical field does mean that investors have a better choice of managers, styles and performance to choose from. There are now ethical funds in the global growth sector from Aberdeen, St James’ Place, Jupiter, Norwich Union, Morley, Halifax, Henderson, Insight, F&C and Neptune. In the UK All Companies sector (see table on page 42) the choice is even wider. There, the ethical funds achieve an average performance over five years of 24.5 per cent as opposed to an average five-year performance of 32.8 per cent for the sector as a whole. The top-performing All Companies Ethical fund, from Standard Life, returns well above the average, with 41.6 per cent over five years.

Organisations that support ethical investing are able to produce figures to indicate that a well-managed ethical fund may perform as well as a non-ethical one. The Journal of Business, Finance and Accounting published new research at the end of last year indicating “no systemic underperformance by screened ethical funds”, according to the UK Socially Responsible Investment Forum. The journal used matched pair analysis on the performance of 60 European funds between 1995 and 2001 and found there was no difference between the two types of fund.

And if the growth of the last few years in ethical investing continues, investors are likely to have even more choice, and perhaps a higher number of high-flying managers attracted to the area. According to the Co-operative Bank’s most recent ethical purchasing index, ethical consumerism in the UK increased by £3.5 billion in 2004, to total £27.7 billion.

Dark green or light green?

To some extent, performance is dictated by how ‘dark green’ or ‘light green’ a fund is. Lighter-green management, such as that practised by Sue Round, co-manager of the Allchurches Amity fund, does allow in a number of the larger companies that many of the non-ethical funds would invest in. In fact, a five year performance line graph of the Amity fund next to the All Share index shows a mirroring effect between the two lines, although Round’s fund line is in the right place: that is, on the top.

The Amity fund uses a combination of positive and negative screening to arrive at the companies it invests in, and so using negative screening would avoid tobacco, arms and alcohol-related companies for example. However, using positive screening, it would try to include companies that incorporated good ethical practices, such as good corporate governance, in their workings. This approach enables it to include index giants such as GlaxoSmithKline, Legal & General and Tesco in its top ten holdings.

Many ethical funds also look at companies from a ‘best in sector’ point of view. F&C’s Ethical Managed Pension, for example, takes this approach which means that it can put money into the companies it deems have the best ethical and socially responsible practices in their sector. This positive approach lets funds which embrace it make money out of a wider variety of companies, including some that would not have been allowed into a darker-green fund. The approach includes rules such as ‘if the positives outweigh negatives, the company is acceptable’ and ‘if a company is best in sector it is acceptable, unless it has a major negative’.

According to its manager Andrew Preston, Aberdeen Ethical World is very much toward the dark-green end of the spectrum. “Our animal testing screen, for example, covers all animal testing,” he points out. “That’s a very stringent one because some people split it into medical testing and cosmetic testing, that allows various pharmaceutical companies in.”

This is where the dark green of the Aberdeen fund would differ from the light green of Amity, which admits companies that use animals for testing medical products, as is required by law in the UK.

However the stocks for the fund are chosen first of all using the same criteria as those for any other Aberdeen fund. A global universe of 2,000 is reduced to 300 companies that Aberdeen’s global desk feels are good enough, and then this is reduced down to the 50 or so picks for the ethical fund using their particular criteria. “The important thing is the fund is based on the Aberdeen process,” continues Preston. “We spend a lot of time looking at companies to get to know and trust the management, then we go back and do the maths. It’s this thorough process which is the key to returns.”

Some ethical funds, particularly historically, have been based in small companies with volatile earnings, points out Preston. Another sign of the times – the increasing interest in ethical funds and their increasing search for performance – is that many are now investing in much larger companies. “We have telecoms, financial services and media companies,” says Preston. “This isn’t a niche portfolio.”

FTSE4Good

The explosion in interest in ethical investing was caused in part by the Pensions Act. In 2001, in response to this Act, part of which required pension funds to disclose whether they take into account social, environmental and ethical considerations in their investment process, the FTSE4Good indices were launched.

“The Act was a major step-change in policy in the UK and stimulated a requirement for a socially responsible investment benchmark that pension funds could use,” explains FTSE’s head of socially responsible investing, Will Oulton. So the FTSE4Good indices were created through whittling down from 2,400 companies from FTSE’s developed world indices to those with good practices in relation to things like environmental issues, human rights and countering bribery and corruption.

“You can make decent money from ethical investing,” says Oulton. “There’s a wide range of choice out there and no standard product on offer. In Europe alone there are 430 to 450 different ethical funds, and they have got different approaches on how they evaluate. Investors really need to look at how the screening process is being applied. For example, is it ‘best in class’ where there are no exclusions, all sectors are represented and they can choose the best of each?”

The UK FTSE4Good index is used as the benchmark for the Co-Op’s Child Trust Fund and also for the Direct Line FTSE4 Good Tracker. According to figures from DigitalLook, the tracker has returned just over 60 per cent in three years.

The top ethical performer in the sector, Aegon Ethical, returned over 100 per cent, but it is perhaps a better comparison to look at other index trackers. The Direct Line FTSE Standard (which would use a similar process to its FTSE4Good tracker) produced 68 per cent over three years. Other trackers produced between 85 per cent (Scottish Widows UK All Share) and –1.51 per cent (Pru FTSE tracker). More trackers outperformed the Direct Line FTSE4Good tracker than did not.

Of course these are crude measures by which to make comparisons, and most fund managers would argue even with the basic premiss of this article, because it is not comparing like for like.

Ethical funds are designed for investors who would like to make some money out of companies that adhere to certain moral and environmental principles, but it is true to say that whilst some are good performers, none of them are top of their sector. Those who invest in ethical funds generally do so because they want to be ethical, a fact backed up by the longevity with which they stay in the funds.

If it’s simply money you’re after, it’s better to keep out of this narrower area, though. Hargreaves Lansdown’s Meera Patel observes: “I can appreciate it if people want to be green and good and help the environment. But if you want to make money, ethical funds wouldn’t be my first choice to put clients into unless they had specifically requested that they wanted to be in that area.”

More and more investors are going for the ethical option nonetheless. Andrew Preston says: “This [concept of socially responsible investing] isn’t going to just wither and die. Ethical funds will be more driven by performance, and the funds must perform to succeed.”

Indeed. It’s one thing adhering to the concept of being a saint but, if you choose the righteous path in your investments, you don’t want to feel you’re being damned as a fool by the sinner.