As National Ethical Investment Week comes to a close, we look into what type of investments are considered ethically sound, the subjective nature of ethical constraints, how ethical investments are designed and monitored, and whether funds’ ethics have an implication for its performance.
It could be argued that taking a stance—whether virtuous or vicious—on environmental, social and governmental issues and applying such boundaries to an investment strategy could limit the ability of the investor to diversify and thus hedge against specific risks, much like investing in a single-sector fund. Furthermore, it could also be said that ethical investing is counterintuitive as investment decisions need to be ruled by the head and not the heart. But investing isn’t just about making money—those investing for retirement of or their children’s futures may want to put their money to good use so as to ensure a wealthier and healthier existence further down the line. To some, it just doesn’t make sense to invest for a child’s education—that same child that you lecture on the evils of smoking, by supporting cigarette manufacturers, or alcohol producers, or arms suppliers, or…banks?
To others, it makes perfect sense to buy into those companies (or countries, in the case of investing in government debt) that supply you with the ‘treats’ that you hold so dear—the British American Tobaccos and the Carlsbergs of the world. This is certainly the premise behind the Vice fund (VICEX)—a fund available to US investors that invests in so-called sin stocks.
But one investor’s ‘ethical’ decision is another investor’s ‘vice’ hankering, so ethical investment dialogue needs to first answer the question of what is considered ethical and who gets to make that call?
Ethics is Subjective
Here at Morningstar, we have refrained from creating an “ethical” category for funds precisely due to the amorphous nature of the term. There are no industry standards of what ethical is, explains Morningstar fund analyst Alexander Prineas . However, a fund’s ethical criteria will be outlined in advance and screening for holdings will typically be performed by an internal ethics research team or outsourced to an independent expert organisation, Prineas clarifies.
Two bond funds that Morningstar analysts covers, Aegon Ethical Corporate Bond and F&C Ethical Bond fund, illustrate the difference in opinion on what constitutes ‘ethical’. Aegon’s ethical bond funds are based on conservative ethics and as such will neither invest in debt of most financial companies nor even of the UK government (gilts and gilts futures). The F&C Ethical Bond fund has slightly more relaxed constraints. The fund’s independent committee of experts responsible for assessing issues on an ethical basis decided in 2007 to lift the blanket ban on financials, on the argument that banks are a necessity and it is better to recognise good and bad banks than completely preclude them.
Investors should be aware of the underlying assets of any fund they pick, be it ethical, socially conscious, or alternative energy focussed, says Morningstar’s Director of Fund Research for Europe and Asia, Christopher Traulsen. “A fund’s title is only reflecting what the fund says about itself,” Traulsen points out. For example, some fund managers take the view that oil companies which allocate portions of their budget to wind energy belong in an alternative energy fund.
Echoing the language of ethical investment independent research provider EIRIS, Traulsen refers to the “best-in-class approach,” which would allow an ethical fund to invest in oil and gas companies, “but only in those oil companies which are ‘best in their class’ as they have a better record on the environment and human rights than others in their sector,” EIRIS green and ethical fund criteria state.
This ‘best in class’ is one of the three approaches to creating an ethical fund portfolio that EIRIS points to. A second approach is screening out activities deemed negative, such as heavy pollution, animal testing, or arms manufacturing, screening in activities deemed positive, such as recycling, organic farming, or renewable energy. Finally, the third approach to creating such a fund is referred to as ‘engagement’, whereby the fund manager actively encourages companies to adopt social and environmental best practices. “Many of the larger ethical pension funds tend to concentrate solely on engagement,” EIRIS say.
No Universally Accepted Watchdog
Part of the reason for the diverse interpretations of what is ethical investment is due to the inherent subjective nature of the term. Part of it, however, stems out of the lack of a universally accepted body, be it public or private, to rank and monitor degrees of portfolios’ social consciousness. EIRIS is one relatively widely recognised non-for-profit organisation which has undertaken this task.
Morningstar Director of Fund Policy & Regulatory Affairs Costas Alkiviadou explains that the fund industry is not completely left to its own devices in sifting the ethical from the not-so-ethical. FSA regulation states that all labelling and information should be “clear, fair, and not misleading,” and therefore while managers have room for interpretation, they would be aware of some fundamental checks and balances on how they brand their investment strategy.
It should be noted, however, that while both EIRIS and the FSA monitor investment products that are domiciled both in and outside of the UK, should an investor wish to file a complaint or recover losses due to misinformation of a supposed ‘ethical’ fund based abroad, this can become increasingly difficult across geographic borders. In addition, the divergence in opinions on what is ethical is bound to widen as funds from other jurisdictions are considered Alkiviadou points out.
Does Ethical Investment Have a Risk or Return Profile After All?
There are certainly funds for which ethical constraints have hindered the fund manager’s ability to respond to changes in the economic climate. For example, the Aegan Ethical Corporate Bond fund, Alexander Prineas explains, by not investing in most financial companies was in a position to outperform during the credit crunch, but was put at a disadvantage during the market rebound. The fund also has a significant holding in building and friendly societies (commonly known as cooperative financial institutions), which have been impacted by credit rating downgrades.
Looking at the F&C Ethical Bond, Morningstar analysts conclude that “while this fund's ethical screens are less stringent than some ethical bond funds', the shrunken corporate bond universe creates inherent biases in the fund and is likely to affect its performance against a broader corporate bond fund. So investing in line with your conscience comes at a price.”
So as ethical and green investing becomes more popular, could investors be looking at ethical investment as a way to hedge against portfolio volatility? “No, historically they probably haven’t, the overweight position of many of these funds in mid-cap stocks has probably been viewed as the opposite,” says Julia Dreblow, Principal at SRI Services, an organisation that offers independent information on ethical and green investing. “But with growing recognition of the importance of environmental and other ethical issues to investment returns, those funds which hold well managed mid- and large-cap stocks will increasingly be viewed as adding more stability, because they are managing those issues which need to be managed in the long run,” she added.
While this cannot be said for all funds, however, Dreblow points out some of the newer, smaller funds, which are looking very much at clean technology and newer opportunities and have been seen as volatile, have actually performed rather well: “Longer term we should see more of those kinds of funds being successful.”
From both the perspectives of individuals and institutions, investors are increasingly focussing on environmental and social governance issues. A testimony of the growing institutional interest is the expanding list of organisation signing up to the Principles of Responsible Investment (PRI) initiative—a voluntary network that promotes a set list of responsible investment principles, endorsed by the UN. “One key thing to mention is the number of global initiatives around social and environmental risks and how to mitigate those risks, and the importance of looking at the long-term risks stemming from these issues,” says EIRIS’s Head of Communications, Mark Robertson, in reference to the PRI initiative. “We are increasingly hearing the point being made that you should be investing in green funds as part of a diversified portfolio anyway,” says Robertson, adding “As funds become more mature around recognising ethical and social risk and taking a more long term approach to these issues, that is only going to be a good thing in terms of risk profile.”
However, it’s important to note that a fund’s ‘ethical’ moniker provides minimal information about its performance. In addition to Morningstar not having an “ethical” funds category due to the ambivalence of the definition of ‘ethical’, there is also the reason that funds with similar moral constraints may differ greatly in regional and sectoral asset allocation or risk profile, says Costas Alkiviadou. Essentially, comparing two ethical funds is not necessarily comparing apples with apples. To explain further, it is not helpful to compare the results of an ethical fund invested in Latin America, which has performed on the back of emerging markets growth, to an ethical fund holding UK assets, the performance of which is based on very different factors, i.e. the difference in their returns will not be the least bit due to their moral considerations. Furthermore, one would be wrong to assume that ethical funds universally outperform or underperform their peers, Chris Traulsen explains.
What Do Investors Want?
At the end of the day, the push towards building an ethical investment brand, or—if you want to be cynicall—the opportunity to make money from it, exists due to an increasing demand from investors. On an institutional level, Chris Traulsen explains, this is more evident in some countries than others: ethical investment is currently a much hotter topic on the Dutch market than on the UK one.
On an individual level, EIRIS research points to a growing interest among the UK consumer. Every year EIRIS administers a survey of over 1,000 British adults seeking to establish attitudes towards green and ethical finance. In the wake of the financial crisis and the BP disaster, the EIRIS survey has been showing an increasing portion of those surveyed say that financial institutions should have regard for social, environmental, and government risks as part of ensuring good financial return.
That said, the survey shows that there are still major concerns that discourage investors from going ethical. A little over 40% of those surveyed said they would switch to an ethical financial product or service if it were verified by an external organisation and if there was a greater choice of products. Meanwhile, 38% indentify lack of available information as a hindrance. Interestingly, 43% of investors say that they would consider more socially responsible options if they are offered by their current provider. Of course, one could infer from these figures that whereas some investors lack sufficient information to invest ethically, others simply lack sufficient heart.
Bottom line, selecting ethical investment products needs to be done on a case by case basis, not least because what’s deemed ethical differs between individual and fund provider, and a fund’s name doesn’t necessarily paint the full picture of the underlying investment strategy. As with all investment decisions, whether your aim is to grow your nest egg or to grow a rain forest, you need to conduct your own research before putting your money where your heart is.
