Ethical funds are a good way to invest money – in principle

In these tough times, people are inclined to put themselves first – but you can still help the planet in doing so

For 25 years, ethical funds have grown in popularity but the financial crisis and a prolonged period of underperformance have started to make investors nervous. The sector actually shrunk by £18.4m during the second quarter of this year – its first net outflow since records began back in 1992, according to the Investment Management Association.

More than £40m was withdrawn during June, which wiped out both the £8.1m net gains enjoyed the previous month and the £13.8m added in May. Considering £22.3m was invested during the corresponding month in 2008, this is a worrying sign. Is this a temporary glitch or a depressing long-term tren?. Are people still convinced they can make money at the same time as helping the planet, or has their enthusiasm been replaced by scepticism?

Before analysing the sector, it's important to put the IMA statistics into context. They should not be taken at face value, insists Adam Ognall, deputy chief executive of UKSIF, the sustainable investment and finance association. "One of the major reasons for the fall is that a fund closed and wrote cheques out to its investors," he explains. "If you look at the funds that are still open for business, most of them are showing positive inflows."

The fund in question was the HSBC Ethical Charity Unit Trust, which was run on behalf of one client and not open to public investment. Its departure, therefore, shouldn't reflect unfairly on the sector as a whole. Even so, research compiled by Investment Life & Pensions Moneyfacts reveals that ethical funds in general have been struggling during the difficult environment of the past couple of years.

In fact, the average ethical fund has dropped 16.74 per cent in value during the 12 months to 1 July 2009, while non-ethical funds have fallen by a margin of 12.3 per cent. Only three out of 60 ethical funds have actually delivered positive growth. It's a similarly depressing story for the year to 1 July 2008, when ethical funds fell 14.2 per cent, compared to an 8.31 per cent drop for non-ethical. The net result is that over three years, the average ethical fund has lost 16.42 per cent.

"Just two years ago, the defence for ethical-fund performance was strong, with returns outstripping those of their non-ethical rivals. Unfortunately, the performance of ethical funds is now lagging behind that of their non-ethical counterparts," says Richard Eagling, editor of Investment Life & Pensions Moneyfacts.

He attributes this mismatch to the composition of many ethical funds and, more pertinently, the nature of where they can invest. "Many ethical funds were unable to invest in defensive sectors such as pharmaceuticals, tobacco, and oil and gas, which performed very strongly in the fourth quarter of 2008," he explains. "By contrast, most ethical funds have a stronger bias towards smaller and medium-sized companies, both of which struggled last year."

So can you actually make as much money in them as in a non-ethical fund – and should they form part of an average investor's portfolio? It's a debate that has been raging ever since ethical funds first became a part of the investment landscape a quarter of a century ago when Friends Provident launched its Stewardship range – now run on its behalf by F&C – to a sceptical retail audience.

The year was 1984, and the chance of tapping in to a social conscience back then was debatable at best; laughable at worst. With the country in the grip of the miners' strikes, saving the planet wasn't exactly high on the list of priorities. However, times have changed and there has been a fairly dramatic shift in the years since, with people willing to consider making changes to the ways in which they live their lives, the products they buy, and the investments they consider.

The amounts held in ethical funds account for a tiny percentage of overall assets under management. Although the total invested in this area has more than doubled to £4.5bn over the past decade, this figure still equates only to a miserly 1.1 per cent share. However, there are plenty of other green and ethical funds available that are not included in these figures as they don't meet IMA requirements, points out Adam Ognall. "There are a number of very large and successful funds that aren't covered, and many of them are still enjoying inflows of cash," he explains. "Overall, during the financial crisis, investors have been very loyal to ethical funds."

In addition, the industry has expanded on the number of products on offer over the past 18 months, which has increased their appeal. "There are now a range of ethical funds offering exposure to different asset classes, and this is important because they will meet the different profiles of different clients," he adds.

There's no doubt the ethical-investing sector is developing and broadening its appeal and the ways in which it operates, agrees Geoff Penrice, an adviser at Honister Partners – and this is good news. Whereas ethical-fund managers would previously employ only negative screening – such as excluding companies involved in tobacco, alcohol and animal testing – they are increasingly looking at positive screening as well.

"This means they will look at companies which are beneficial to the environment or which have a good track record in promoting workers' rights," he explains. "Fund managers also use their position as shareholders to encourage ethical behaviour in the companies which they invest in; this is known as shareholder engagement."

This appeals to many – as highlighted by a spokeswoman for the Ethical Investment Research Service (EIRIS). "The ethical investor gains more than just a return from their investment," she says. "Their savings represent an investment in the world's future, too."

Periods of underperformance are to be expected when you are dealing with funds that screen potential investments says Karina Litvack, head of governance and sustainable investment at F&C. "As you're dealing with a constrained investment universe, you will have some differences in performance over shorter periods, but over the longer term, research shows they [ethical and non-ethical funds] tend to perform the same," she says.

Andy Gadd, head of research at Lighthouse Group, concurs. Investing in ethical funds must be considered over the course of an economic cycle, he insists, citing as an example the Co-operative Insurance Sustainable Leaders Trust. "This was the best-performing fund in the 'UK: All Companies' sector for the 12 months to 31 January 2007," he explains. "Although recent performance has been disappointing, this fund still outperforms the sector and the FTSE All-Share over three and five years."

So how important will the role of ethical funds be in the future? Litvack is convinced that the qualities displayed by companies that are seen as offering gold-standard best practice today will become the norm tomorrow. "In predicting the future, I would look at the past," she says. "The really remarkable fact you've seen in the last 25 years is that things which seemed outlandish and fringe have become completely mainstream."

These mainstream investments will, therefore, absorb an increasing number of the tenets of sustainable investment, she suggests. "This means ethical investing is going to continue to be about spotting the new trends and adopting them, which means more risks sometimes but also anticipating them before they become big themes."