Could the grass be greener for ethical investors?

If they select tomorrow's winners then profits won't be going up in smoke on the altar of principle

Green is the colour. The appetite of ordinary investors for ethical funds has been reinvigorated over the past six months.

"Following good stock market performance, investing is back on the agenda, and more and more people are looking to ethical options," says Jonathon Clark of independent financial adviser (IFA) Barchester Green. "There has been a spurt of activity, with a range of new [ethical] funds coming on to the market."

Since last summer, there have been green launches from Skandia - a "multi-manager" where, for a slightly higher fee, your money is split between four other ethical funds; Standard Life Investments - an ethical corporate bond fund; and Jupiter - an environmental income fund.

Today, nearly 500,000 individual investors have money in some 60 ethical funds provided by over 30 financial services institutions, according to research from IFA John Scott & Partners.

Green investing is also about to get a shade darker. In the next few weeks, asset manager King & Shaxson will launch an ethical balanced-income fund that puts your money in a mix of UK shares, bonds and property.

Crucially, it has "dark green" screening criteria, says manager Wayne Bishop. Along with the traditional avoidance of gambling, tobacco and arms, "the exclusions from this fund include [companies investing in] air and road transport, fossil fuels, intensive farming, nuclear power and pesticides," he explains.

Companies involved in animal testing for cosmetic purposes are also excluded, but animal testing for medical reasons is allowed.

In some industry sectors, the fund will opt for "best in class". For instance, banks are shunned unless they either have little exposure to corporate lending or a special focus on socially or environmentally beneficial projects, Mr Bishop stresses.

The new fund's eligibility rules highlight a concern for many ethical investors: just how green is my fund? After all, one person's ethics might be another's idea of exploitation. For example, "light green" funds usually avoid companies engaged in animal testing for non-medical purposes, and in armaments and tobacco, but may invest in "best in class" businesses in the oil, drugs and banking sectors.

To check a particular fund's criteria, the directory at www.ethicalinvestors.co.uk (an IFA website) is a good starting point. It offers a free A-Z of all ethical funds and ranks them according to three key yardsticks: humanism, animal protection and environmentalism.

The last of these appears to be of the greatest concern to ethical investors. According to new research by Standard Life Investments, the clearing of tropical forests and the manufacture and supply of ozone-depleting chemicals are the top two priorities, followed by human rights.

Green criteria aside, the most common criticism of ethical investing is that profits may be sacrificed for our principles.

For example, because the exploitation of fossil fuels is ruled out, many of the funds don't put money into the oil sector. And over the past 12 months, oil stocks have been among the best performers on the UK stock market.

A glance at the performance of ethical funds over the past three years underlines the cost of a conscience.

Over the three years to 18 January 2006, the average return posted by all investment funds in the UK All Companies index is 72.8 per cent. There are 13 ethical funds in the sector and only four of them have beaten this average. These are Aegon Ethical Equity (87.6 per cent), Old Mutual Ethical Managers (86.2), Standard Life Investments UK Ethical Trust (79.9) and Norwich Union UK Ethical (75.4).

Examine figures scrutinising performance over five years, however, and half the ethical funds beat the sector average.

Anyway, says Mr Clark at Barchester Green, ethical investors may be picking tomorrow's winners.

"Companies that meet these criteria generally have good employee practices, maintain ecologically sound policies, set environmental targets and make energy-saving products," he argues. These provide "excellent yardsticks for [picking ] forward-looking companies, which can lead to good share price returns".

For further information, go to www.trustnet.co.uk, www.eiris.org.uk, www.foe.co.uk