This article aims to explain the different types of strategy that ethical funds may adopt and why ethical funds shouldn’t be overlooked when aiming for capital growth.
Why consider ethical investment?
There is a growing desire to make a difference to the world we live in. More of us are recycling our waste, watching our fuel consumption and perhaps trying to buy fair trade products. We can extend this to our investment decisions too. For many investors, how and where their money is invested is as important as the potential returns.
Principles and performance
Investors are increasingly keen to balance their desire for investment performance with maintaining a clear conscience – and with a growing choice of ethical investments and changing corporate attitudes there need be little compromise. Many investment experts now fundamentally believe that investment companies which manage their businesses in the most responsible manner are also likely to see some of the strongest share price performance in future years.
Ethical investment strategies
Fund managers generally have a criteria to select companies for inclusion, including the three most commonly employed criteria: positive screeningPositive screening A positive screening strategy means a fund will seek to invest in those companies with a commitment to responsible business practices, positive products and/or services., negative screeningNegative screeningNegative screening is the most commonly recognised strategy. It means not investing in companies that do not meet the ethical standards by which the fund is run. For example, not investing in tobacco or defence companies. and engagementEngagementAn ethical investment fund may follow an 'engagement policy' by using the influence of shareholders to challenge companies about their environmental or social performance. This means entering into a dialogue with companies to improve their environmental or social policies and to promote industry 'best practice'..
Types of ethical investor
Broadly speaking, you may be able to match your clients to one of these particular outlooks…
- Conscience decision investors – their main priority is to avoid holdings in companies involved with activities they disapprove of. These are quite likely to be single issues, and could be anything from tobacco to animal testing or armaments. A negative screening strategy may be the most appropriate criteria to use to make a decision for this type of investor.
- They may prefer the ideas of themed investing – actively looking to invest in companies that 'make a difference', perhaps in areas such as climate or healthcare. For this type of investor, positive screening may be the appropriate criteria to use to make a decision.
- If they wish to promote responsible corporations – particularly opposed to issues such as excessive remuneration within large corporate organisations – typically this type of investor will want to see the fund provider using engagement or voting rights to encourage corporate responsibility. For this type of investor engagement may be the appropriate criteria to use to make a decision.
Is ethical investment inherently riskier?
The level of risk an investor is willing to accept is a crucial consideration. It is important to remember that when investing ethically the same risks and principles apply. It's generally known that diversification reduces risk. If you screen out unethical investments it could be argued that you are potentially limiting the scope for diversification within a portfolio.
But in terms of stock market based investments, it can also be argued that less ethical companies are running a business risk by undertaking social or environmental practices that might attract negative media or consumer attention. In addition, with carbon credits and scarce resources there is risk in some companies that they will be charged to pollute or have to pay high prices for raw materials that could have a detrimental effect on their future profitability.
There is also a strong argument to suggest that companies with good ethics also follow good business practices. And today this is more relevant than ever – especially considering some of the horror stories involving business ethics such as accounting scandals that have brought large global corporations to their knees.
Alternative route to success
Different areas of the market can display different characteristics and while a fund manager may be restricted from investing in, say, tobacco – an area characterised by solid and reliable returns – similar characteristics can be found in other areas, such as gas, water and electricity companies.
At other times real alternatives can be found. Investment in Alternative energy companiesAlternative energy companiesCompanies working in and supporting the renewable energy sector., for example, can be a successful strategy in an environment of high oil prices when governments, businesses and individuals are keen to explore 'alternative' energy sources.
Ethical investment funds
The amount of money invested in ethical funds has grown rapidly, increasing substantially in the last decade. There are now well over 100 ethical pension and investment funds available in the UK and the popularity of such investments looks set to continue.
Shades of green
When thinking about whether to recommend an ethical fund, it is useful to understand the ethical policies followed. What sorts of companies are considered for investment and what checks are there to ensure these criteria are rigorously followed? There is a wide range of funds with different approaches to choose from:
'Dark green' funds
These have the strictest investment criteria, avoiding investing in companies that have a poor record on environmental, human rights or other ethical grounds. Dark green funds normally exclude companies involved within the defence, tobacco, gambling and alcohol sectorsSector A sector is a grouping of funds with a similar investment objective and make up.
An area of the economy where businesses share the same or a related product or service, for example, pharmaceuticals, telecommunications or retail., as well as others such as mining companies.
'Light green' funds
Usually with a broader remit than 'dark green' funds, these often take a 'best of sectors' approach. They don’t normally avoid whole sectors but often concentrate on the most socially responsible companies in a particular sector.
Other types of ethical funds
These include funds that invest in companies specifically because of the positive contribution they make to the environment. Recycling companies or those involved in renewable energies such as solar or wind power come into this category. These are examples of positive screening. In reality, most ethical funds – including 'dark green' ones – also invest in such companies.
There is no screening involved in these funds, instead they focus on using their influence as shareholders to challenge companies about their environmental or social performance. In practical terms, this means entering into a dialogue with companies to improve their environmental or social policies and to promote industry 'best practice' along with a continuous improvement in the way they run their businesses.
Targeting climate change
It is widely accepted that swift action needs to be taken on potential implications of climatic change. Companies are under ever mounting pressure to act. National or multinational policy directives, non-governmental pressure groups and, increasingly, individuals are expressing their preference for those companies or products which have a less detrimental environmental impact. Many leading companies are now considering it best business sense to actively address climate change.
Investors are also becoming increasingly active, whether it is through the avoidance of areas/firms contributing to climate change or by positively selecting those companies providing a potential solution.
Many green and ethical investment funds adopt this approach, as well as seeking to influence corporate behaviour and the regulatory framework in such a way as to harness the market to achieve the best environmental outcome for society. Some ethical funds will target specific sectors and companies for engagementEngagementAn ethical investment fund may follow an 'engagement policy' by using the influence of shareholders to challenge companies about their environmental or social performance. This means entering into a dialogue with companies to improve their environmental or social policies and to promote industry 'best practice'. to impress the need for clear policy guidance at a government level and accountability and action from companies.
Many investment experts firmly believe that better environmental practices will ultimately mean improved corporate performance – which is good news for investors.
As an example, some ethical and environmental funds will look to identify and take advantage of investment opportunities in areas such as alternative energy which offer solutions to identifiable problems such as the world's over-reliance on fossil fuels.