The term 'ethical' is often used as a catch-all term to describe any fund that is managed with social, environmental, or other ethical criteria 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 appeal to 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 outperformed the broader UK stock market over the past year. Audrey Ryan’s ability to select companies with bright futures was particularly strong amongst businesses in the industrials and technology sectors, according to our analysis. Long-term performance has been impressive, helped by a bias towards higher-risk small and medium-sized companies, which have outperformed their larger counterparts over the manager's tenure.
Audrey Ryan has been at the helm of this fund for more than 19 years and we believe she is one of few managers to have handled the constraints of an ethical fund well over the long term.
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, UK corporate bond prices have generally remained high and default rates low, meaning the fund’s defensive positioning detracted from returns over the past few years.
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 and is a concentrated portfolio. Both of these factors increase risk.
The manager’s track record is short, but he benefits from the support of a team we have long held in high regard. The fund underperformed its benchmark over the past year, but we believe the team will do a good job for long-term investors, although there are no guarantees.
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 invest this fund quite differently to its peers 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.
The fund produced a return ahead of its benchmark over the past year. Although long-term returns have been strong, the fund has largely underperformed the broader global stock market since 2010.
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 is currently biased towards bonds issued by financial companies and those that provide the bondholder a claim on the company’s assets in the event it's unable to repay its debts.
The fund outperformed its benchmark over the past year. Recent purchases include bonds issued by social housing association London & Quadrant and United Utilities, the water company. Please note the fund also invests in higher-risk high yield bonds.
This fund invests in shares and bonds issued by UK companies of all sizes with the aim to generate an attractive level of income. We consider it to have a ‘dark green’ approach.
Catherine Stanley combines her views on the economy and individual businesses to build a portfolio capable of generating income over the long term. Companies that derive a significant proportion of their income from gambling, pornography, tobacco or weapons are omitted from her investment universe.
Our analysis suggests the fund’s bias towards higher-risk small and medium-sized companies has helped performance, but the fund has only marginally outperformed the broader UK stock market over the manager’s 9-year tenure.
Please note the research updates are not personal recommendations to trade. If you are unsure of the suitability of an investment for your circumstances please seek advice. Remember all investments can fall as well as rise in value so investors could get back less than they invest.