Where there isn't muck, there's brass

Ethical investors don't have to sacrifice returns, writes Simon Hildrey. They just have to work harder in finding the right fund

When the tobacco group BAT sold its 60 per cent stake in Rothmans of Pall Mall Myanmar earlier this month, it became the last UK company to withdraw from Burma. Government pressure to quit a country with one of the most oppressive regimes in the world had simply grown too great.

However, it is rare that a UK government takes such a strong line with multinationals. Usually, the only pressure on companies comes from the collective power wielded by investors in socially responsible funds.

Those who run these funds argue that companies that disassociate themselves from oppressive regimes and poor working conditions in Third World countries, or that enhance their social, corporate governance and environmental policies, strengthen their brand in the medium term - which, in turn, improves their stock market performance.

This argument clearly has some currency because funds have evolved from a strictly ethical stance - where stocks and industries are excluded if they harm the environment or breach human rights - to socially responsible funds that take a more proactive approach in trying to improve corporate behaviour.

There are more than 50 ethical and socially responsible funds with over £4bn in assets under management, according to the Ethical Investment Research Service (Eiris). It suggests that investing according to ethical criteria "may make little difference to overall financial performance, depending on the ethical policy applied". As evidence, Eiris says five of its indices produce financial returns roughly equivalent to the performance of the FTSE All-Share index.

But ratings agency Standard & Poor's counters that ethical investors do have to sacrifice performance. Despite the recovery in the stock market, the average ethical fund has underperformed the FTSE since mid-March and over the past one, three and five years (see table below).

Like any other sector, however, the performance of ethical funds varies widely. In the past three years, the Isis Stewardship Income fund has delivered a return of 5.05 per cent compared to a 22.72 per cent decline in the FTSE All-Share. Over the past five years, the Isis fund is up 26.29 per cent, compared with a 2.11 per cent fall in the FTSE. Since mid-March, the Morley SF UK Growth fund has delivered a return of 31.32 per cent compared to 28.86 per cent by the FTSE All-Share.

Of course, the table shows that other ethical funds have underperformed. Amanda Davidson, a partner at indepen- dent financial adviser Charcol Holden Meehan, says: "There are good, bad and indifferent ethical funds. When choosing one that meets your ethical criteria, the decision process is the same as with any other fund. Investors have to look at its track record, the manager and the team, and the mission statement."

Ms Davidson adds that while investors do not need to lose out on performance, they may experience more volatility because they are unable to diversify as widely as with conventional unit trusts. "This does not mean performance suffers over the long term, however," she says. "Performance depends on the quality of the manager and his research team."

To reduce volatility, Ted Scott, who manages Isis Stewardship Income, invests up to 35 per cent of his portfolio in high-yielding stocks such as utilities and corporate bonds, while the rest goes into growth stocks. This flexible approach offsets not being able to invest in two of the largest sectors usually favoured by income managers: banking and oil.

Although 75 per cent of the stock market (by capitalisation) is off-limits to Mr Scott, that still leaves a universe of more than 600 companies in the FTSE All-Share. Managers say this means that ethical funds have to be actively managed, focusing particularly on small and mid-cap stocks. Investors are not in danger of buying a closet index-tracking fund.

Noel Smyth, product specialist in socially responsible investment (SRI) at Morley Fund Management, also argues that the advantage of ethical over conventional funds is that greater analysis goes into a company, partly because the manager has to determine whether it can be included in his portfolio.

"Issues such as climate change and the ageing population will benefit some companies and sectors, and detrimentally affect others. Ethical funds can take advantage of this through their research."

If you are interested in ethical investing, you don't have to sacrifice performance - although if you buy an average fund, this may well happen. To reduce the chances of this as far as possible, it is important to select funds on the basis of their manager, team, past performance and investment approach, as well as ethical criteria.

Cleaning up

The best-performing UK ethical and ecological funds

Name of fund Return

Isis Stewardship Income 26.29%

Sovereign Ethical 8.48%

Old Mutual Ethical 7.37%

Family Charities Ethical 7.13%

SW Environmental Investor 6.7%

Banner Real Life 5.74%

SW Ethical -1.7%

Standard Life UK Ethical -3.44%

Allchurches Amity -4.4%

Isis Stewardship Growth -4.94%

Figures show performance over the past five years (9 November 1998 to 10 November 2003)

Source: Standard & Poor's