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Ethical funds have always inspired debate in the financial industry, with opinion divided or whether they can stand up on investment as well as moral terms.

This month has seen a significant milestone for the industry, with F&C’s Stewardship growth fund – the first such pooled product in Europe – celebrating its 25th anniversary.

But while ethical assets in the UK now account for almost 7bn, the sector has struggled to find a mainstream audience.

F&C’s own range highlights the issue that many have with these products – performance has been worse than many mainstream, and therefore broader, competing funds.

The group has come under particular fire for adding some high-street banks to its universe in 2007, just prior to the credit-crunch-inspired carnage in the sector. Its independent committee of reference allowed some non-mortgage banks in, claiming many have integrated ethical considerations into their operations.

Morningstar figures show Stewardship growth has lost 27.6 per cent over 12 months to June 1, 2009, ranking 233rd out of 305 funds in the UK All Companies peer group. Over three years, it is down by 25.5 per cent, sitting 234th out of 272.

According to F&C, the focus on banks as the source of underperformance is incorrect as the Stewardship funds have been underweight the sector before and after the policy change.

F&C head of corporate affairs Jason Hollands says Stewardship growth’s worst quarter in a difficult 2008 was the fourth, when it had just over 4 per cent in banks.

Its relative underperformance over longer periods is down to last year, which Hollands attributes to the ethical restrictions being the strictest in the market.

Other dark green funds have also struggled while those using positive screening – focusing on companies improving ethical standards – have faced a slightly easier ride.

Hollands says: “Defensive sectors led the market last year and the fund is unable to invest in around half the stocks available, with tobacco, many pharmaceuticals and most oil companies ruled out.

“These funds are also small and mid-cap by their nature and suffered as blue-chips led the way. Our Stewardship range can only invest in two of the UK’s biggest stocks and around 60 per cent of the FTSE 100 is off limits.” He also feels comparisons with other ethical funds are not always like for like, with many competitors focusing purely on environmental factors and several investing globally.

Looking at major competitors, most have suffered over the last year – although not as badly – but have lost considerably less over the longer timeframe.

Another dark green fund, Aegon ethical equity, is down by 26.6 per cent over 12 months but has only shed 11 per cent over three years, ranking 61st out of 272 in the UK All Companies sector.

Elsewhere, Jupiter Ecology posts figures of -23.1 per cent and -4.1 per cent for one and three years respectively and Henderson Industries of the Future -18.5 per cent and -4.4 per cent.

Lack of financials is evident in these portfolios, with both holding under 2 per cent in this part of the market.

Hollands says the Stewardship funds have outperformed the market at various times during their life, particularly when small and mid caps are in the ascendancy.

But he believes the relentless focus on return compared with non-ethical peers ignores the fact that ethical investors do not want to hold certain companies. He says: “Our lack of defensives like tobacco, oil and pharma has hurt performance but Stewardship investors have chosen to avoid such areas as a point of principle. You would not convince a pacifist to invest in defence companies just because there are decent returns of offer.”

Aegon ethical equity manager Audrey Ryan has also been unable to invest in the surging defensive areas of the market, with her screens still blocking out all the high-street banks.

She says this lack of banks helped recent numbers and she has also been longer in cash than some of her peers to protect against the worst of the markets.

Ryan says: “My fund has faced headwinds in not being able to hold beverages, tobacco and other defensive names but I have to deal with that. Through stockpicking, it is possible to capture some defensive earnings in areas like support services and healthcare.”

Of the other high-profile ethical portfolios, Henderson’s Industries of the Future has benefited from a global mandate and thematic approach including environmental and social elements.

Deputy manager Samantha Cotterell says this twin focus allows the vehicle to perform in different conditions, with social themes driving returns in 2008.

Also hit by the move to large caps, the fund has benefited from holding very little in financials and also sold down clean energy stocks as valuations entered bubble territory.

Manager Tim Dieppe highlighted contributions from the knowledge, environmental services, quality of life, safety and efficiency themes last year.

He says: “Each of these has a combination of counter-cyclical characteristics supported by regulatory or cost-saving features.

“Safety and environmental services stocks also performed well in the recessionary environment, supported by regulatory drivers that require companies to invest in health, safety and environmental programmes regardless of the climate.”

Looking forward, Dieppe says the background remains tough but points to surprisingly consistent support given to climate change policies in key regions around the world.

“New legislation in the EU and UK includes demanding new commitments on carbon emission reductions and growth targets for renewable energy,” he adds. “The election of Barack Obama in the US also bodes well for cleaner energy and efficiency stocks operating in these markets.”

Jupiter ecology manager Charlie Thomas also invests in key environmental themes, seeking out companies set to benefit from the green transition.

Like most ethical investors, he focuses on small and mid caps, so has suffered from the recent blue-chip migration but tends to hold stocks on a three to five-year basis.

In common with the Henderson approach, his thematic process largely screens out financials so the fund avoided the worst of the banking carnage last year as well as the recent rally in the sector.

Ecology is another global portfolio, with Thomas picking stocks across water, waste, clean energy, environmental services, green transport and sustainable living themes.

In terms of current opportunities, he highlights areas such as renewable energy and energy efficiency and says the solar sector is looking interesting again after valuation concerns.

Again, Thomas believes the background for environmental issues has completely changed, with unprecedented investment coming into this area.

He says: “If you strip out the green elements from all the stimulus packages announced, the amount earmarked is 15 per cent of $475bn, which is more than the environmental sector has ever seen. In previous recessions, environmental issues fell off the agenda but this is clearly no longer the case.”

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Much of the recent press coverage marking ethical investing focuses on the 25th anniversary of the launch of the F&C Stewardship growth fund.

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