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A question of ethics

Despite their socially responsible credentials, ethical funds have largely failed to capture the imagination of IFAs and their clients. Although there are dozens of ethical funds in the market, few funds are big enough to command attention and their performance in general – with notable exceptions – has been distinctly underwhelming.

One of the exceptions has been Friends Provident&#39s pioneering Stewardship growth fund which celebrates its 20th anniversary next month.

Friends, one of the most vociferous champions of ethical funds, is marking the milestone with a CPPI fund which has its equity component linked to the flagship growth portfolio. Despite this link, how-ever, few IFAs have shown much interest in the new portfolio, a consequence, they argue, of the problems inherent in socially responsible investing in general.

Alan Steel Asset Management consultant David Scott says: “I always ask clients whether they have any ethical concerns and nine out of 10 say no. All they want is an investment that will make them money and, in my view, there are lots of other nonethical funds which are more likely to do that.”

Scott says the main problem is that ethical funds must screen out hundreds of companies, restricting their managers to an abnormally narrow investment horizon.

Hargreaves Lansdown argues that performance will suffer if managers are hamstrung by non-sector-based constraints. Throw in the confusion about what does and does not constitute an ethical investment and HL believes that investors will be better served elsewhere.

Senior analyst Meera Patel says: “Investing in the stockmarket is like gambling. If an investor is prepared to take a gamble – which is something that goes against many people&#39s ethics anyway – then why not invest in a fund where returns can potentially be maximised within their risk profile?” But ethical fund managers say their approach is neither unusual nor a question of personal ethics.

Morley, one of the most prominent socially responsible groups, with seven ethical funds under management, says criticising the ethical screening process is criticising active fund management as a whole.

Business relationship manager Noel Smyth says: “How is a mainstream UK fund manager excluding a sector different from what an SRI manager is doing? Could that UK manager explain why every stock he or she does not hold has been excluded? It is unrealistic to believe that there are sound financial reasons behind the omission of every single stock.”

Smyth also takes issue with the “outdated” assumption that ethical investing is based on an arbitrary form of personal morality. He says that by screening some companies or sectors, groups are simply excluding stocks which they believe will not perform over time due to their involvement in particular industries.

For example, Morley will not consider investing in companies which may be affected by forthcoming environmental legislation which in its view could hit their long-term earning potential.

Friends takes a similar line, arguing that, if anything, its screening process enhances its funds&#39 performance. Head of investment marketing Ian Jeffries says: “IFAs have taken this view that screening hurts performance but it is not borne out. In our experience, screening is in no way detrimental. In fact, it is helpful in identifying firms with good management practices.”

However, Jeffries acknowledges that groups often have different concepts of what constitutes ethical investing, a long-held IFA bugbear. Standard Life&#39s screening process, for example, is considered to be “light green” – meaning it is less stringent than many others, including Friends.

But some of the more ethical-friendly IFAs argue that, as with more mainstream investing, it is simply a matter of striking the right balance to suit clients&#39 needs.

Kingsworld Walder chairman Robert Banks says: “Processes can be different but you need to balance out what is reasonable. Performance can be more volatile with ethical funds but it certainly does not have to be worse. Clients have to accept that it is not always possible for their fund to be in the top half of the sector but we have never had any difficulty with that.”

Many of Banks&#39 clients, however, are charities which have far more regard for ethical investing than the typical high-net-worth client. They are therefore liable to be more forgiving than most during the inevitable periods of underperformance which can accompany ethical funds, especially as most are skewed towards small and mid-cap stocks.

Chartwell Investment Management investment analyst Ryan Hughes says: “Ethical investments do attract a certain type of person. Most are prepared to sacrifice performance but, for the mainstream public, the story is very different – there is only support for it in principle. Not many would invest on pure investment grounds.”

Nevertheless, Hughes is at pains to point out that performance can be outstanding in certain cases. Friends&#39 Stewardship income fund, for example, has returned 35.8 per cent over five years, trouncing the -0.1 per cent sector average and only slightly behind Credit Suisse&#39s flagship income fund which, with Bill Mott at the helm for much of the period, has grown by 36.7 per cent.

This performance, however, is not typical of the ethical sector and most ethical fund managers would have a hard time arguing their case on figures alone. But is that the point?

After all, those seeking an ethical investment are often ambivalent about whether their fund is top-quartile. The problem for fund groups is that there may not be enough people around prepared to sacrifice performance for their ethical concerns.

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