Giving the green light for light green investing by John Reeve

29th June 2009

The financial crisis has shaken many investors’ faith in the stock market. While the FTSE 100 has rallied since January, many long-term investors are still sitting on substantial losses. Ethical fund returns have been particularly hard hit and have often underperformed mainstream funds.

However, interest in ethical investing remains very strong, and there are signs the turmoil of the past 18 months, rather than putting investors off, will actually benefit funds with a more socially responsible outlook. Many fund managers are looking on in envy at the inflows ethical funds are now experiencing.

Ethical funds have evolved considerably since the first, the Stewardship Growth fund, was introduced by F&C in 1984. This fund and subsequent ethical products initially used screening techniques that restricted stocks according to strict criteria, which some investors felt limited potential returns.

As ethical funds have evolved, they have begun to utilise ‘softer’ screening techniques that allow for more flexibility in terms of investment options. The perception that the choice is between an investment strategy that satisfies the conscience and achieving growth is one that is gradually being broken down.

The nature of ethical investment has changed dramatically in the past 25 years as the social and political issues that inform the sector have evolved. Wider issues to do with corporate responsibility, for example, have been incorporated into the realm of ethical investment criteria. In addition, investors are realising ethical investments are long-term commitments and, despite recent underperformance, believe they will outperform in the long run.

Shades of green

The ‘dark green’ approach historically used by ethical funds, which involved the process of negative screening, is gradually being replaced by a more flexible approach. Negative screening usually automatically excludes companies involved in ‘sin stocks’ such as tobacco, alcohol, armaments, gambling, the fur trade and pornography. Other businesses excluded from investment can include those with a poor human rights record or that have previously dealt with political regimes criticised for human rights abuses.

The more flexible ‘light green’ approach used by many of the newer funds concentrates on positive screening. This approach identifies investable companies that score highest when rated on various social, environmental and ethical criteria, such as those active in renewable energy, waste recycling or green technology.

Another approach employed by some managers sees a fund use its stake in a company to influence changes in the way it operates, with the aim of improving corporate responsibility.

It is interesting to note that, over the past six months, the FTSE4Good UK 50 Total Return index has matched the rally seen in the FTSE 100 index. The FTSE4Good measures the performance of companies that meet globally recognised corporate responsibility standards. These include making a positive contribution towards environmental sustainability, upholding and supporting human rights and ensuring good supply-chain labour standards.

The downturn has dual implications for the ethical investment sector. The first is a short term reaction in terms of a sudden and sharp reduction in the value of ethical funds, reflecting a wider collapse in financial markets globally. This has brought renewed focus on the viability of ethical funds as an effective investment channel.

A second effect has been that sustainability and social responsibility have moved even closer to the top of the business and investment industry agenda. From renewable energy initiatives to the reduction of carbon footprints and the exposure of dubious investment and outsourcing practices, what were once mainly political issues are becoming recognised as integral business issues. With illusory short-term profit-seeking considered broadly irresponsible and even unethical due to the knock-on effects it can have, mainstream ideas of money generation have changed.

Some risks remain

Despite the growing interest in ‘green’ investment, it is still the case that funds are quite specifically targeted and make up a tiny proportion of the overall investment market. As with any investments, there are potential issues and risks.

Certainly, there is a risk ethical funds may miss out on the strongest individual recoveries in equities over the next few months. Ethical funds are not focused on profiting from short-term opportunities in the market, and rules surrounding their investments may rule out some of the strongest performing stocks.

Short-termism is not an appropriate perspective from which to view ethical funds. In the past, ethical funds have tended to perform well in bursts as they usually coincide with strong performance in mid-cap stocks, in which these funds are heavily concentrated. However, ethical funds are designed with the long term in mind, both in terms of the types of companies they tend to invest in and the general predilections of their investors.

There is also the consideration that, to maintain the significance of the ‘ethical’ tag, guidelines may be tightened. The proliferation of ‘lighter green’ strategies makes ethical funds more accessible to the investor who wants assurances his money is being directed towards worthy causes, but who also wants to make a decent return, avoiding the risk associated with a very narrow range of stock options. There has been sporadic criticism that not all green funds are operating to the same standards.

Ethical funds appear to be adapting as themes of social responsibility and sustainability resonate more strongly with mainstream ideas of growth. This applies for both companies and individuals. For those targeting long-term growth, as well as the peace of mind that the money is being invested in worth causes, ethical funds remain popular. This is why the profile of ethical, although small, is rising, and the reason why it is set to continue.

John Reeve is chief executive of Family Investments. This article originally appeared in Investment Advisor, June 2009.

Main points

• In the past 25 years, issues around ethical funds have generally evolved away from ‘dark green’ strategies of negatively screening out ‘sin stocks’ towards more flexible ‘lighter green’ screens and active engagement processes.
• Ethical funs are not focused on profiting from short-term opportunities in the market, and rules surrounding their investments may rule out some of the strongest-performing stocks.
• In the past, ethical funds have performed well in bursts as they tend to coincide with strong performance in mid-cap stocks, in which these funds are heavily concentrated. However, investor outlooks and SRI fundamentals make these long-term investments on the whole.
• Tighter guidelines are expected to ensure ‘lighter green’ strategies do not become so broad and flexible as to neglect their ethical objectives.

 

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