The term 'ethical' is often used as a catch-all term to describe any fund that is managed with social, environmental, or other ethical criterion in mind. In reality, there are a number of different ethical strategies and a fund manager may employ one or more of these when managing the fund. The main approaches to ethical investing are as follows:
- Exclusion (negative screening) – this involves avoiding companies not meeting certain criteria or involved in certain activities, e.g. tobacco, alcohol etc.
- Preference (positive screening) – in this case sectors are not avoided. The manager will assess each sector, looking for the 'best-in-class'.
- Engagement – managers of these funds will actively engage with the companies they invest in to promote socially responsible business.
An ethical investment fund which has strict negative screening in place could be referred to as having a 'dark green' ethical approach. Funds which focus more on positive screening or engagement could be referred to as 'light green'.
Our view on the Ethical sector
Ethical funds come in many shapes and sizes. It is important to clarify a fund’s approach, particularly towards ethical screening, to ensure it meets your objectives. A strict ‘dark green’ approach, which excludes certain industries entirely will suit some investors, while others will be happy with a ‘light green’ approach, which seeks companies operating in a socially responsible way and striving to improve their industry, regardless of what industry that is.
The in-built biases many ethical funds have will influence performance and potentially make them more volatile. UK smaller and medium-sized companies performed poorly in the wake of the UK’s referendum on EU membership, for example, and this affected funds with a bias to this higher risk area. However, in the few years prior to the referendum a bias to smaller and medium-sized companies was generally positive.
On balance we prefer an unconstrained approach to investment because this gives fund managers the flexibility to invest wherever they see the best opportunities. We believe this should result in the best returns for long-term investors.
Many ethical funds share certain characteristics that can affect their performance (positively or negatively) when certain areas of the stock market are performing well. These characteristics include:
- A bias to economically sensitive or ‘cyclical’ companies – many industries excluded by ethical funds, such as tobacco, beverages (alcohol) and some healthcare companies, are considered more 'defensive'.
- A bias to smaller and medium-sized companies – large companies tend to have more diversified businesses, increasing the likelihood they will be engaged in an activity deemed 'unethical'. This rules out a lot of larger companies and ethical funds tend to invest more in medium-sized and smaller companies, which are higher risk.
- Lower yields – some of the areas excluded by ethical funds include higher yielding sectors (tobacco, oil & gas etc.). This makes it harder to generate an attractive income and there are not currently many ethical income funds around.
The areas ethical funds tend to have a bias to have generally performed better when the outlook for the economy or stock market was good. In contrast, larger, defensive companies, in a strong financial position, with stable earnings and high dividends have tended to perform better during uncertain times.
Our favourite funds in the sector
Other funds in the sector
Source for performance figures: Financial Express
A UK-focused fund with a bias to higher-risk smaller and medium-sized companies and more economically sensitive sectors. We consider it to have a 'dark green' approach.
The fund underperformed the FTSE All-Share over the past year, partly due to its lack of exposure to mining and refining companies, which performed well over the period. The manager’s stock selection also detracted from returns, according to our analysis. Despite some short-term setbacks, in our opinion long-term performance has been impressive, helped by a long-term bias towards higher-risk small and medium-sized companies.
Audrey Ryan has been at the helm of this fund for more than 18 years and, in our view, she is one of few managers to have handled the constraints of an ethical fund well over the long term. A separate team at Kames is dedicated to screening out companies involved in activities such as alcohol, gambling and tobacco. Having a separate team to take care of the ethical screens means the manager is free to concentrate on picking the best stocks within the universe available to her.
This fund holds shares in Hargreaves Lansdown plc.
This fund invests predominantly in investment-grade corporate bonds and has 'dark green' ethical screening criteria in place, which excludes sectors such as tobacco, arms and gambling.
The managers are cautious on the prospects for corporate bonds and have therefore positioned their portfolio defensively by investing primarily in the bonds of high-quality companies, which typically provide lower yields. Despite their concerns, bond prices have remained high and default rates have remained low, meaning the fund’s defensive positioning detracted from returns over the past year.
That said, the managers are supported by a well-resourced fixed-interest team at Kames which we hold in high regard. We view this fund as a good option for investors seeking an ethically-managed bond fund. Please note the fund also invests in higher-risk high yield bonds.
This fund invests globally in companies of all sizes including higher risk smaller companies. The emphasis is on positive, rather than negative, ethical screening – a ‘light green’ approach.
Nick Edgerton and his team invest in the shares of companies deemed to have a positive impact on society, the environment and health. This approach means they are unlikely to invest in certain companies, such as tobacco, alcohol, and weapons, but they are not specifically excluded. Investors should note the fund has some exposure to emerging markets which are more volatile and higher-risk than developed markets.
The track record of this fund is short, but it is managed by a team we have held in high regard for many years and we believe they will do a good job for long-term investors.
A global fund which combines negative and positive ethical screening alongside engaging with company management. This is a 'dark green' ethical fund.
Robin Hepworth, the fund’s manager, is willing to deviate significantly from the benchmark to concentrate on the areas where he sees value. The fund is currently biased to higher-risk Asian markets, where he believes companies with sustainable qualities are being overlooked by other investors, and Europe where companies could benefit from the region’s improving political outlook, in his view. The fund has underperformed its benchmark over the past year which is partly a result of the manager’s poor stock selection, according to our analysis.
This is an investment-grade corporate bond fund using a ‘lighter green’ approach. The manager seeks companies aiming to make a positive impact, as well as excluding those in industries such as alcohol, gambling and pornography.
The main attraction of this fund is that it is managed by the experienced Eric Holt and his team. They are willing to look for opportunities off the beaten track, in areas under-researched by other investors. The fund outperformed both its benchmark and its peers over the past year, helped by its bias towards bonds issued by financials, particularly banks and insurance providers, which performed well over the period.
Invests in FTSE 350 Index companies selected according to ethical and environmental guidelines meeting Ethical Investment Research Services (EIRIS) criteria.
Companies significantly involved in water pollution, intensive farming, gambling, adult entertainment, weapons manufacturing and tobacco sales are filtered out of the FTSE 350 index. The fund then aims to track the performance of the remaining companies. To achieve accurate tracking of the performance of this modified index, it invests in a broad spread of representative companies from the index.
Premier Ethical aims to invest in the shares of companies that benefit the community or the environment, while avoiding those that negatively affect human health or have significant involvement in gambling or the arms trade. We consider it to have a ‘light green’ approach.
The fund outperformed the FTSE All-Share over the past year, partly due to its bias towards strongly-performing, but higher-risk, small and medium-sized companies. The manager’s stock selection also strengthened returns over the period, particularly in the industrials sector, an area to which the fund is biased. We would like to see the manager accrue a longer track record of adding value for investors before considering the fund for the Wealth 150.