The environment is top of the political agenda once again, with the Chancellor announcing a new "green tax" on flights in this week's pre-Budget report, just days after Joan Ruddock, the Climate Change minister, said that investors had a vital role to play in turning companies "green".
Investors, she said, must send strong signals to the market over the importance of a company's environmental record in making investment decisions.
Ethical investment has many definitions, but essentially refers to funds that select stocks on the basis of ethical, social or environmental criteria.
"The defining feature is 'screening'," says Julia Dreblow, socially responsible investment (SRI) manager at Friends Provident. " But these funds are also expected to give a decent return to investors."
Ethical investment essentially falls into three groups. First off are the traditional ethical funds. These appeal to investors with a wide range of concerns who are happy to invest in a way that avoids socially irresponsible or ethically dubious companies, while supporting the businesses which abide by a more ethical code. These include the Stewardship Fund from F&C. Second, are old-school "green" funds that invest in line with an environmental theme – such as the Jupiter Ecology Fund.
Finally, there are funds that employ an "engagement approach" – where shareholders use their position to encourage companies to behave more responsibly. So, while these products might invest in more dubious companies, they try to change them for the better from within.
Ethical investing is not a new phenomenon; the F&C Stewardship Income Fund was launched in 1987, while its sister fund, Stewardship Growth, is a few years older. This was the first retail ethical fund, screening out companies involved with pollution, armaments, tobacco, alcohol, gambling and pornography, as well as actively targeting those companies making a positive contribution to society and the environment.
"This is no 'fad' sector," says Philippa Gee, of independent financial adviser Torquil Clark. "Serious investors have been able to invest in this way for decades. However, it has become cool to be green; the demand has grown significantly, which has led to an increase in the range of funds available."
An important distinction to make is that between the traditionally-run ethical funds and the new generation of climate change funds.
"Companies in the latter may not fulfil ethical criteria, and so should only be considered by investors who believe that the opportunities posed are relevant," says Gee. "On the other hand, ethical funds could come from any sector, but have to pass certain validation tests in terms of what will or will not be allowed."
Dreblow argues that the new climate change funds are not so different from the traditional ethical funds. "These funds will appeal to the same people and are a natural extension of the ethical movement," she says.
She adds that there is a lot of talk about climate change not screening stocks. "The approach is different, but they do have a reduced universe in which they can invest," she says. "This cuts down the number of companies the fund managers can invest in, and is therefore similar to screened funds."
She is also concerned about the view that the newer climate change funds are all about performance, saying that this implies ethical funds are not.
"The big difference is the number of issues ethical funds screen for, compared to what climate change funds are looking for," she says. " Ethical funds look at issues as diverse as human rights, labour standards, genetic engineering, nuclear power, smoking, armaments and so on. Climate change funds focus on just one main issue – and therefore theoretically cuts out fewer companies – although the way this feeds through to investment strategies will vary dramatically."
This issue of performance is one of the criticisms levelled at ethical funds. Critics argue that as they screen out some stocks, the "universe" for investing is reduced. But standing by your principles does not have to mean sacrificing profits, according to recent findings from financial analyst Moneyfacts, which showed ethical fund returns were "surging ahead" of those on offer from mainstream traditional funds.
Over three years, it found that ethical funds were outstripping non-ethical funds with average growth of 57.2 per cent compared with 52.3 per cent – while the FTSE 100 index grew 48 per cent.
"This has helped to shatter the misguided belief that sustainable business practices restrict company growth," says a Moneyfacts spokesman.
But Gee adds that while certain ethical funds have entered the performance tables having achieved strong performance in the last three years, investors should tread carefully.
"While it is great that ethical funds are delivering strong returns, my concern is that investors may go in for the wrong reasons," she says. "Ethical or climate change funds suit certain long-term investors who have particular investment requirements, but they are not a way to make a fast buck. They will not always be in the charts and there will be times of underperformance. That said, I anticipate that demand will continue to grow."
Companies with a conscience: the fund managers' choice
The ethical arena can be a good place to hunt for stock ideas. On the environment side, these opportunities are more apparent than ever, says Alex Illingworth, manager of the Halifax Ethical fund.
"The need to find other forms of electricity generation and legislation on reduction of CO2 emissions mean we have sectors showing strong signs of secular growth," Illingworth says. "One such area would be in solar. Costs of production are coming down so quickly that this technology is increasingly becoming cost-effective. Stocks of interest would be Q.Cells, a solar cell manufacturer; or Roth & Rau, which makes equipment to make solar cells."
Mark Hogg, deputy fund manager of the CIS Sustainable Leaders Trust, picks out the RPS Group, an environmental consultant, and Aggreko, a global provider of rented portable power systems.
Hogg's stock tips in the sector also include Scottish & Southern Energy (SS&E); Johnson Matthey, provider of catalytic converters; and Smith & Nephew, developer of innovative healthcare products.
"The Government's commitment to electricity generation from renewable sources is creating excellent investment opportunities for SS&E, which is one of the largest developers of wind generation in the UK," Hogg says. "Johnson Matthey has benefited from global regulation on the automotive industry to reduce the environmental impact of their vehicles."
Hogg also recommends AIM-listed Spice, a utility network maintenance company, which helps to repair leakage in the water network.
On the small-cap side, the Stewardship fund manager Ted Scott picks out Waterman, an engineering and environmental consultancy, and Wincanton, a specialist logistics provider, which enables companies to comply with the Waste Electrical and Electronic Equipment (WEEE) Directive and with other recycling requirements.
Choose wisely: funds with a responsible ethos
Philippa Gee recommends the Schroders Global Climate Change fund.
"This enables you to access the possible benefits of being invested in companies that will be part of the climate change transformation – providing goods and services designed to help the world limit, or adapt to, climate change," she says.
The fund, which has just been launched, will invest in about 60 companies, including natural gas suppliers and solar power industries. "The two fund managers have a sizeable research team to call upon," Gee says.
She also picks out the F&C Stewardship Growth Fund, which, she says, adopts a "mix of positive and negative criteria. The fund manager, Ted Scott, has been head of Stewardship Investments since 2000, while his deputy manager is a smaller-company specialist," she says. "They take a 'barbell' approach, so there is exposure to some companies that are held for capital growth purposes, which generate little income, while at the other end, some of the companies held generate very high income. There is significant bias to small and medium-sized companies, and as at least 130 companies are held, the fund is well diversified."
Another recommendation from Gee is the Jupiter Ecology Fund, which invests in companies responding positively to and profiting from the challenge of environmental sustainability, and which are making a positive commitment to social wellbeing.
"This equity-invested fund generally has around half invested in the UK market and the remainder overseas – usually comprising around 100 companies," she says. "Research is undertaken by the in-house environmental team, with negative criteria applied in a strict way – allowing them to invest in companies that might not otherwise be excluded, provided that activity does not account for more than 10 per cent of their turnover. There is a significant bias towards small and medium-sized companies."
Other recommendations from Gee include the Standard Life UK Ethical and the Aegon Ethical Corporate Bond.