How ethical funds find the gems and avoid sin stocks

In 1984, Friends Provident, an insurance company with a Quaker heritage, unveiled a range of ethical funds that excluded companies that "do not meet the ethical standards of the funds or harm society' and supported companies that made 'a positive contribution to society".

Are firms becoming more ethically conscious?

It seems ethical investing or its modern incarnation - socially responsible investing (SRI) - is now gaining momentum at both a macro level and among individual businesses: last year Mark Carney, governor of the Bank of England, argued that investors could face huge losses as a result of climate change.

A few months later, at the Paris climate change agreement, ministers from 196 countries signed an agreement to limit their nations' emissions to relatively safe levels.

Financial advisers believe that the agreement might affect the decisions of pension funds; for instance, one of Sweden's largest pension funds committed to low carbon investing a few months after agreement was reached.

State action is likely to encourage corporate initiatives in the sustainable sector.

Meanwhile, there are signs that companies are becoming more ethically conscious. Earlier this year, Axa announced its intention to divest from the tobacco industry, an entirely logical move given that Axa is one of the world's largest health insurers.


Over the past couple of years the ethical investment sector has been on an upward path, although with less than £12 billion under management it remains a small part of the £950 billion strong UK industry.

We look at the ethical investment processes of these funds and explain the two very different methods that are used.

Negative and positive screening

Traditionally, ethical funds have used a process called negative screening to exclude companies that produce weapons, tobacco, alcohol, porn, gambling and nuclear power.

In contrast, positive screening focuses on investing in companies that make a positive ESG (environmental, social and governance) contribution by having good human rights, labour rights and equality records, for instance.

While negative screening tends to be product-based, positive screening is conduct-based. Today, there are around 90 collective investments that use avoidance, inclusion, or a blend of the two, estimates John Ditchfield, partner of financial advice at Castlefield.

“Negative screening is a simple approach to markets, that avoids activities which have a detrimental impact on human life, like smoking,” he says. Meanwhile, “the bit of the market that captures people's imagination and interest tends to be in positive investment”.

The fund managers we spoke to use a combination of the two methods. “First we start with a negative screen,” says Bryn Jones, manager of the Rathbone Ethical Bond fund.

“If the company has one negative aspect, it can't go into the portfolio, and it has to have at least one positive aspect, such as environmental impact or good working practices including gender and racial equality.”

Jones is looking, for instance, for banks where the proportion of women on the board mirrors that of the female workforce in the company. Some Scandinavian banks fulfil this criterion.

Jones explains that companies are excluded when it comes to producing things like tobacco, but distributors do not fail the negative screen test.

“A supermarket that might distribute tobacco products is not prohibited, and a negative screen doesn't necessarily prohibit the banks which may help to finance the product.”

Jones emphasises that the ethical criteria screening is validated by an external company, while he is in charge of evaluating companies' merit as an investment.


Profitable investment areas

Just like other open-ended portfolios, ethical funds invest in areas they consider potentially profitable on the whole. For Jamie Jenkins, head of the responsible global equities team at F&C, healthcare is such an area, due to the advances in healthcare and ageing populations in the West.

Jenkins also values companies which help in the transition to a lower-carbon economy. He says the complete exclusion of fossil fuels would be premature at this stage, as “vast swathes of the global population need fossil fuels for power generation, because the renewable energy infrastructure is simply not there”.

In emerging markets in particular, he says, there would be a “heavy societal near- and mid-term cost to bear in terms of unemployment and deterioration in living standards”.

But over the next years he expects to tighten the fossil fuel criteria for inclusion in F&C SRI funds, as “there is a rising interest in deploying lower-carbon technologies and phasing out fossil fuels for all the obvious ecological reasons”.

According to Eric Holt, manager of the Royal London Ethical Bond fund, “a negative screen is black and white, while a positive screen is grey”.

Commenting on negative screens, he says: “Within all those [excluded] sectors, the magnitude of the opportunity that we are excluded from is relatively modest.”

Some ethical funds that use negative screens have “good quality practices when it comes to positive engagement with companies”, says Ditchfield. But others have failed to adapt. Further, there may be a disconnection between the way society is headed and what negative screening seems to offer.

“People are more pragmatic about their ethical screens, perhaps less driven by moral conviction and more driven by social concerns - that's reflected in the development of the funds that we're seeing,” says Ditchfield.

He cites the approach of the WHEB Sustainability fund and Impax Environmental Markets trust as examples.

“ESG is already becoming a new norm,” says Paula Oliveira, executive director at management consultancy Brandcap.

She argues that “if companies don't invest in ESG, their competitors will, and they'll be left behind by their customers, partners and even employees, as millennials are much more interested in companies that match their values and strive to fulfil a bigger purpose than just profits”.


Assessing performance

Some research has shown that applying a positive screen may lead to stronger performance than applying a negative one.

“The maximum abnormal returns are reached when investors employ the best-in-class screening approach, use a combination of several socially responsible screens,” wrote Alexander Kempf and Peer Osthoff, professors of finance at the University of Cologne in a study from 2007. But overall, other studies are not so conclusive.

This may be because “there is no universally accepted definition of what SRI means and therefore many studies use different definitions, typically too broad, in my opinion, to truly capture genuine commitment to sustainability and social responsibility issues by portfolio companies”, says Ioannis Ioannou, associate professor of strategy and entrepreneurship at London Business School.

As everyone screens in a different way, explains Ioannou, “you could really get either positive or negative results”.

Given that there are over 90 ethical investment products in the UK, it's too simplistic to say a particular screen has a certain effect on performance, agrees Ditchfield. Instead, investors need to understand each product individually, what it does and what it achieves.

Recently, there has been a debate around whether you can achieve ethical investing with tracker funds, he notes. Organisations such as Morningstar have supported this by creating ESG indices. Morningstar scores companies' ESG performance and flags those companies as investable to funds.

But Ditchfield points out one potential flaw, which is that the indices tend to focus on large companies which have the scale to produce the data to be included in these indices.

For instance, Royal Dutch Shell spends a lot of money to produce extensive data on its ESG, whereas a small renewable energy business in the US might not score so highly because of its reporting process.

For Jones, ESG indicators can help to protect investors by mitigating some of the risks associated with bad environmental and social impact and poor governance. “There has been a change in perception,” he says.

Investors “used to screen out an ethical fund [specifically] because it was ethical”; now mainstream investors are interested in using such funds. At the same time businesses have become more conscious of ESG.

Additionally, says Jones, more bonds for social good are being issued, such as Thera Trust, which supports people with learning disabilities.

“There is a lot more demand than supply, which is a story in the bond market more generally, let alone in a niche component of it,: he adds. “Why not buy an ethical fund, if it can perform well and do good at the same time? For a lot of investors that makes sense now.”

Kames Ethical Equity sticks to its guns

In the wake of Brexit, ethical funds which are overweight in UK mid-caps have suffered, just like funds without ethical mandates.

Ryan Smith, head of corporate governance and ethical research at Kames, says the Kames Ethical Equity fund, which only invests in UK-listed equities, will stick to its guns.

The fund has a bias towards small and mid-cap stocks and is underweight defensive sectors and resources (oil, gas and mining).

“Recently, this position has been a drag on performance, as has the fund's overweight position in financial services, life insurance, general retail and media.

“Post the referendum outcome, the fund has further reduced domestic-related stocks and selective financials which are likely to struggle in the low growth and low interest rate environment of the coming months.”

But on a positive note, Ditchfield explains that many sustainability funds he rates have a global approach. A lot of innovation in the renewables space is driven by big companies in North America and Asia.

“Sustainable investors could well have an advantage [at present], given their portfolios tend to be more international,” he says.

This article was originally written for our sister magazine, Money Observer.

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