How to invest if the only way is ethics

Remaining green in a volatile market is tricky. Chiara Cavaglieri finds out how to avoid the sinful sectors – and not lose out

Ethical investors always have it tough, but never more so than in a volatile market.

Traditionally, defensive stocks are "sinful" sectors, such as oil and gas, tobacco and pharmaceuticals, but is there a way to protect yourself and keep your ethical credentials when markets are in turmoil?

Ethical investment, or socially responsible investing (SRI), can work is several ways, but the ultimate aim is the same – how can investors combine a desire for returns with a concern for social, environmental and ethical issues? Flick through the information sheets of some of the most popular UK funds and you're bound to see some of the big FTSE 100 firms, whether an oil giant such as BP, British American Tobacco, or weapons makers BAE Systems.

Avoiding the big players can be complicated. Ethical investing can mean just choosing individual firms that you deem socially or environmentally responsible and/or opting to avoid others. But when you are picking an ethical fund, as most private investors prefer, it can get tricky.

First, if you have a fund manager deciding which firms meet the right ethical standards, you may find that your understanding of these standards differs. "Ethical funds adopt a number of different controls, or screens," says Danny Cox from independent financial adviser Hargreaves Lansdown. "Some of these act positively: for example, the manager chooses to invest in clean-energy companies. Others act negatively: the fund manager may exclude companies involved in the production of alcohol, tobacco or firearms."

To make life easier, ethical funds are often referred to as different shades of green; the darkest green funds have the strictest ethical positioning and a greater number of, or more stringent, negative screens. You can decide how dark a shade of green you want to be and choose your funds accordingly. Several IFAs pick out the Jupiter Ecology "light-green" fund, which focuses on firms providing solutions to environmental and social problems, such as clean energy, environmental services, sustainable living and green transport.

This doesn't necessarily reflect well on returns, however, as ethical funds often underperform other investments. For example, in the three years to the end of September 2011, Jupiter Ecology returned 1.13 per cent, whilst M&G Global Basics is up 25.92 per cent.

"The main reason for this is a standard fund can pick and choose whichever funds conform to their wider agenda – this range is known as a 'universe'. Naturally due to both positive and negative screening, an ethical fund has a much smaller universe, and less choice normally means worse performance over time," says Mr Cox.

Mining stocks, say, have taken off in recent years but must be screened out by the vast majority of ethical funds. But this doesn't mean such funds cannot offer decent returns, or cannot work well in a defensive portfolio, particularly as many green funds steer clear of the banks – a positive for them in recent years. Compare Kames Ethical Equity, a dark-green fund, with Jupiter UK Growth over the year to the end of September and the ethical fund is down 4.79 per cent, but Jupiter UK Growth is down 8.18 per cent.

And, as John Fleetwood, the director of Ethical Money Limited, says: "Not all defensive stocks are necessarily 'unethical'. For example, public infrastructure funds, timber plantations, pharmaceuticals, telecoms, utilities."

Experts say that although many ethical funds have been badly affected by market falls, it is outdated to suggest that fund managers without access to sectors such as tobacco and armaments cannot limit risk for investors. "Given the market turmoil we would favour a fund with a pragmatic investment approach with a large-cap bias, such as CIS Sustainable Leaders," says Mike Horseman of IFA Cockburn Lucas. "Concentrating on ethical/green bond investments via Standard life Ethical Bond and/or F&C Ethical Bond will help dampen risk further."

There are also fund managers who engage with companies so that they don't exclude investment but try to influence them in their social practice, as well as those employing what is known as the "best-of-sector approach".

"Managers will try to choose companies [with] the best record in practice within that sector," says Mr Fleetwood. He names BT in telecoms, say, or "perhaps" HSBC among the banks.

Turning to savings accounts, Islamic banks have some market-leading rates on sharia-compliant accounts, which must avoid tobacco, alcohol and pornography. Islamic Bank of Britain offers a best-buy rate of 4 per cent on a two-year bond, beating the average 3.37 per cent, says Moneyfacts.co.uk.

The likes of The Co-operative Bank, Ecology Building Society, Charity Bank and Triodos Bank all offer decent accounts too. Northern Rock offers the top rate of 3.11 per cent for its easy-access account, but with the average account paying a miserly 0.92 per cent, Triodos Bank's Online Saver Plus, at 2 per cent, is attractive. These banks support businesses they believe operate for positive change – renewable energy, say, or societal, or cultural projects. Crucially, you know where your money is going and who it is helping.

"If you compare us to many of the high-street banks I think we offer good value," says Huw Davies, the head of personal banking at Triodos. "We also offer this social return; savers know what their money is doing and they know that it is doing good."

Case Study

Emma Gray, 32

From Huddersfield

Emma was looking for a place to invest £2,000 inherited, at 22, from her grandfather. She split the money equally between the Jupiter Ecology Fund and the Jupiter Environmental Opportunities Fund.

Emma still has these investments, but when she was looking to convert a cash ISA to a stocks-and-shares ISA, she turned once again to ethical funds, investing £10,000 with Hargreaves Lansdown. "I don't want my money to be used by companies that have no regard for the effects their business has on the environment or the welfare of local communities," she says. Her money is split between Jupiter Ecology and Kames Ethical Equity Fund, as well as a smaller sum in a higher-risk fund, BlackRock New Energy.

Emma and her husband have a two-week-old daughter and are already investing £50 a month for her in the Aberdeen Ethical World fund. They are also planning to save into a Junior ISA.