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If it says 'ethical' on the label, that doesn't mean it's whiter than white

Some funds are more exacting than others in the sectors they screen out on behalf of 'clean' investors. Danielle Levy reports

When the Archbishop of Canterbury was embarrassed by the revelation earlier this year that the Church had invested indirectly in Wonga – after he had announced plans to take on the payday lender – it served as a bleak reminder that even the best-intentioned investor can be let down by their so-called ethical investments.

If you are looking to put your spare cash to good use by investing "ethically", be warned that you could face similar nasty surprises unless you keep a keen eye on the investment criteria. A close examination of the ethical fund sector shows investments in some unexpected areas. They include oil companies operating in tar sand fields, deemed harmful by some environmentalists; arms manufacturers; and businesses that have exposure to fur and animal testing.

John Ditchfield of Barchester Green Investment, a specialist adviser, says funds may not always set the bar as high as investors would like in screening which companies are acceptable: "According to the threshold screening process, if an arms manufacturer only made up a small amount of the underlying business activity of a company, then that could be viewed as insignificant. Our view is investors don't see it that way. If an investor wants to avoid arms manufacturers, they want to avoid it entirely."

So how can potential investors avoid getting caught out? First, be clear about your ethical aims and priorities. This will have a bearing on the strategy you follow.

National Ethical Investment Week, which kicks off today, highlights the diverse range of strategies on offer. "There is no one set of rules for this. The whole point is to provide a variety of different options in the market so people can have their needs met in different ways," says Stephen Hine of Eiris, which produces research on the ethical, environmental and social policies of companies.

The Investment Management Association, a trade body, currently counts 51 funds that invest with an ethical bias. They apply "negative screening" to potential investments and typically exclude alcohol, tobacco, gambling and defence. However, as Mr Ditchfield says, fund managers may be given a degree of flexibility with exclusions. He recommends Kames Capital as a provider that is rigorous in the way it negatively screens stocks.

Mr Hine adds: "If you are adamant that you don't want to invest in tar sands, for example, you would be better off in a fund that does not invest in fossil fuel at all. It is a matter of doing your homework."

Christine Berry of ShareAction, a charity that promotes socially responsible investment (SRI), urges ethical funds to be open with investors: "I would say be transparent about your criteria, so consumers don't get a nasty shock when they see the investment."

SRI funds take a distinctive approach, applying "positive screening" by targeting companies that seek to address green issues such as energy efficiency. Mr Ditchfield recommends the Wheb Sustainability fund in this sub-sector, alongside the Cheviot Climate Assets fund.

Ms Berry says investors interested in the sector should pay due attention to whether the fund has a robust governance structure in place to monitor underlying investments and ensure engagement with investors. "It is probably something consumers don't think about, but it can tell you a lot about how committed a provider is to ethical criteria," she says.

If you are investing through a financial adviser, Ms Berry adds that it is important to make sure they have relevant expertise and really understand your objectives.

Regardless of the investment criteria or screening process of any ethical fund, she believes that fund managers in the sector must do more to influence the companies they invest in – to get them to raise their game. "There is a perception that ethical investing is just about screening out bad companies. One thing all ethical funds can do is to engage with companies to improve their ethical performance. The industry is only just catching up with that."

In the same way consumers now buy fair trade coffee as part of day-to-day life, some expect that demand for applying similar principles to savings and investments will spur further growth in the sector. Eiris estimates that around £12.1bn is currently invested in ethical funds in the UK, having grown by just over £1bn over the past 12 months. Although Mr Hine anticipates further growth, he suggests that fund managers could do better in the way they promote their strategies to consumers. "The area has grown considerably and there is huge potential for future growth, but lots of people find it hard to find out about these funds."

Ms Berry, meanwhile, questions whether the sector is responding quickly enough to what ethically minded consumers actually want. For instance, ShareAction research suggests that investors are less concerned about negative screening, preferring to focus on issues like improving labour rights, human rights and environmental policies within the companies where they may hold a stake. "I think the whole market has been slightly slow in developing a range of new funds that address these issues," she says.

But if you want to invest ethically, will you lose out in comparison with mainstream funds?

Performance within the sector varies markedly. Some active funds invest in shares in the UK and abroad, others in bonds, while tracker funds tend to invest in a basket of stocks.

Hine says investors have nothing to fear over the longer term. "These funds tend to perform in line with the market over time." Standard Life Investments' UK Ethical fund, which applies positive and negative screening to UK shares, is testimony to this. It is the top performer in the sector over the past three years, having delivered a 58 per cent return versus an average of 46.8 per cent in the equivalent mainstream sector.

However, Mr Ditchfield warns that some ethical equity funds can prove more volatile if they exclude larger, and safer, companies and have more exposure to riskier smaller firms.

Overall, if you want to invest while taking care of your conscience then don't simply plump for a fund because it says ethical. Check its selection criteria or you could end up falling into the same holy mess as the Archbishop of Canterbury.

Danielle Levy is a Citywire reporter