With ethical stocks struggling, is it time for serious investors to ditch their morals?

Forget noble ideals. When a ship is sinking, it is a rare person who doesn't adopt the mantra of "every man for himself". It's the same with money. Hence, as economies and markets plummeted in 2008, it became ever more difficult to invest with a clear conscience while also making excellent returns. With energy companies, defence businesses and cigarette makers amongst the best performing companies last year, investors were forced to think twice about their itching consciences. But are ethical funds always a write off in a recession, or could now be the perfect time to rediscover your morals for a slice of significant long-term gains?

Limited choices

At the beginning of 2008, private investors in the UK had the ethical investing bug. In February, research by Co-op Insurance found that 85 per cent of equity ISA investors were considering investing in ethical funds last year, up from 67 per cent the previous year. Twelve months on, the ethically focused Co-op is unlikely to even repeat the research.

"Making a decision to overlay the broad downward trend with extra criteria will always reduce your opportunities for the best returns from across the market," says Ian Shipway, managing director of Blue Fin Wealth Management. "You need to be sure of your investment objectives. I'm not anti-ethical, but by choosing only ethically aware funds, you limit yourself to good, ethical choices, but ones which will not give you the best returns."

Particularly in the current global environment, ethical funds could be more likely than normal to miss out on better-performing companies and sectors, he adds. "Active fund managers are getting heavily involved in tobacco and defence stocks, for example, because both of these are expected to perform in contrast to the current economic trend," Shipway says. Addicted smokers won't easily cut back on cigarettes, especially in times of stress, and heightened tension and conflict around the world means that governments will still buy weapons. These are exactly the types of stocks excluded from ethical funds. Cash-strapped consumers, too, are under pressure to bypass fair-trade goods in favour of cheaper, less ethically sourced ones. The fair-trade coffee brand Cafedirect, for example, was purchased by 18 per cent of consumers buying ground coffee between January and March last year. By December, according to the comparison site MySupermarket.com, that figure had dropped to 13 per cent.

Choice is much more limited for ethical investors too - with ethical funds accounting for just 1 per cent of the fund universe as a whole.

Nevertheless, investment returns among ethical funds have not been too bad over the past year, relative to regular funds. According to the investment research company Morningstar, the average UK-domiciled ethical fund was down 25.69 per cent over the last 12 months – almost exactly the same as the FTSE All-Share index. In contrast, the average UK All Companies equity fund was down almost 30 per cent.

Commitment counts

Advocates of ethical funds will also tell you that committed ethical investors have more staying power when things get tough. Almost two-thirds of socially responsible investment (SRI) fund managers reported net inflows of money over the last six months, according to Citi Investment Research. "This is a strong message that those who invest ethically are more loyal than mainstream investors," says Seb Beloe, head of SRI for Henderson Global Investors. "They are not just investing for the financial returns – they are looking for secure environmental and social progress. Those who have made ethical steps are unlikely to retrace them."

In the medium to long term (where financial advisers believe we should focus our investment goals), those who don't take environmental changes into account when investing "should have their heads examined", Beloe adds. Environmental and ethical industries are being promoted by governments and organisations around the world, he argues; companies that fail to support the movement are being penalised.

But cashing in without compromising personal principles is less straightforward than it may seem: most people are unaware of the vast spectrum of inclusion and exclusion criteria.

Shades of green

There are two different types of ethical fund: environmental or climate funds, and SRI funds with ecological and social concerns. Different managers will invest in companies with varying levels of ethical commitment.

Some environmental funds, for example, only invest in clean-technology companies promoting a cleaner environment; such funds are often known as "dark green". Or they will exclude companies or sectors that add to the destruction of our environment, such as oil and gas firms. But some "light green" funds will simply invest in companies that use energy more efficiently than others in their industry.

On the SRI side, arms manufacturers or gambling companies would likely be excluded. But some funds may include, say, car makers that also occasionally make aircraft carriers. Investors need to assess these screening criteria not only in terms of personal ethics but financial expectations as well.

"There is a general overriding commitment around the world to tackling climate change and related social issues," says Ben Yearsley, investment manager for Hargreaves Lansdown. "There is huge investment for the development for green energy, for example. Therefore there are opportunities for people to come into the sector to make money in the long term.

"But you have to decide whether you are chasing the returns or the sustainability... You must accept that to achieve the returns, you will probably have to sacrifice some of your ethical convictions. Ticking all the ethical boxes may not get the same returns – but if that is your focus, you achieve your investment goals." Nor does an ethical focus exclude investors with no ethical leaning, he adds. "If you think a fund will make you money, and that is your selection criterion, it doesn't matter whether it happens to also be ethical."

Hargreaves Lansdown offers a green fund comparison tool at www.h-l.co.uk/funds/ethical-investment-fund-comparison-tool. For a good balance of ethical conviction and fund performance, Yearsley recommends the Jupiter Ecology fund (down 21 per cent over the last year, but up 50 per cent over five years), the F&C Stewardship Income fund (down 33 per cent over the last year, up 2.5 per cent over five years) and Aegon's Ethical Equity fund (down 26 per cent over one year, up 31.5 per cent over five years). For more security, there's the Rathbone Ethical Bond or Aviva's Sustainable Future Corporate Bond; and some 15 insurance companies and fund managers offer ethical ISAs for investments of up to £7,200, including Legal & General.

Responsible investment: Spotting the opportunities

Olivia Bowen, of ethical independent financial adviser The Gaeia Partnership, believes socially aware funds can help investors ride out volatility. "I like 7IM's Ethical Fund," she says. "It aims to lower risk by providing diversity, which is reflected in the fund's performance.

"The Ecclesiastical Amity range often shows its worth when markets are volatile," she adds. And Jupiter's Ecology Fund comes up as a favourite. "It remains a leader for capital preservation and consistent returns," says Bowen.

As for individual stocks, Mike Fox, of the Sustainable Leaders Trust at The Co-operative Asset Management, believes a number of socially-focused companies should be able to weather the storm. "Healthcare should be able to grow even through a downturn. Smith & Nephew specialises in hip and knee replacements. As the baby boomer generation enters retirement, the company is likely to see demand grow for its services.

"Scottish & Southern Energy is putting social responsibility at the heart of its business with initiatives such as a responsible pricing policy for its energy supply business."

Fox also recommends social housing developer Connaught. "Social housing will see substantial investment as the Government aims to improve the standards for tenants," he says. "Connaught works with local authorities across the UK and should be well placed to grow regardless of the economic situation."

More information

The UK Social Investment Forum runs an information website at www.investability.org.

The Ethical Investment Association ( www.ethicalinvestment.org.uk) provides lists of ethical financial advisers in the UK.

A list of ethical fund performance is available via www.trustnet.com and www.morningstar.co.uk.

For in-depth research information, visit www.trucost.com and www.eiris.org.