Ethical funds have been around since 1984, when Friends Life launched its innovative Stewardship range. This was closely followed by launches from F&C and Scottish Widows in 1987, and Premier and Kames (formerly known as Aegon) in the 1990s; today there are over 60 open-ended funds focusing on ethical and sustainable issues available to private investors.
However, these funds account for just 1.2 per cent of the Investment Association's (IA's) universe, as strong growth has failed to materialise.
Reasons include reluctance within the financial services industry to develop ethical funds or encourage their take-up, particularly in the financial adviser community. But perhaps it is the general ignorance still surrounding these vehicles that is more important.
ETHICAL INVESTING BEGINNINGS
Ethical investing grew largely out of religious movements such as Quakerism, which sought to exclude 'sin stocks' such as tobacco, alcohol, gambling, pornography and arms.
As both society and industry has evolved, investors' perception of 'ethical' has changed to include ideas about good corporate governance as well as socially responsible, sustainable and environmental factors.
The range of funds now available to UK investors reflects this, with a number of funds now focusing specifically on sustainable or environmental factors such as clean or alternative energy, rather than simply ethical or moral issues. However, little has been done to communicate these nuances effectively to investors.
As John Ditchfield, director of ethical and sustainable advisory firm Barchester Green observes, 'ethical' has now become a problematic fund label that has the potential to mislead investors unfamiliar with the area.
'The ethical label has become tarnished because a lot of companies have exploited it. They will produce products that don't really fit with what ethical investors want. In the FTSE4Good index - a widely used ethical fund benchmark - you've got HSBC and Shell, and not many ethical investors are going to look at that and say, "yes, that's what I want to be part of",' he says.
Ditchfield cites Aberdeen Ethical and L&G Ethical as examples. In both cases the funds have holdings that many would be surprised to see in an ethical portfolio, such as EOG Resources - one of the US's biggest environmental polluters - as well as FTSE 100 miner Antofagasta and Lloyds Banking Group.
Generally speaking, funds with ethical in their title will employ what are known as negative screens to filter out companies from certain sectors that are deemed unethical. Typically these include the traditional sin stocks; however, the number and combination of sectors a fund excludes can vary widely.
For example, Kames Ethical Equity has strict negative screens for tobacco, alcohol, gambling and pornography, and its portfolio will not include firms in these sectors. Other funds, such as L&G Ethical, Aberdeen Ethical and Premier Ethical, have more opaque criteria, with the only notable exclusions being tobacco and arms manufacturers.
However, for some investors negative screens are inherently problematic, as they look at companies in a two-dimensional way. Thus, for example, while HSBC might not be a traditional sin stock, many might find its tax practices unethical.
What is more, it can be difficult to discern where a company derives all of its earnings: for example, hotels may source some of their earnings from pay-per-view pornography channels available for guests.
Some ethical funds therefore take a 'best-in-class' approach, which allows for investment in 'unethical' sectors as well, but only in those companies with a better record on social or environmental issues than others in the sector.
Positive screening singles out companies that are making an active contribution towards society and/or the environment, rather than excluding companies or sectors on ethical or moral grounds.
Typically, funds that take this approach will have sustainability, environmental or SRI (socially responsible investment) somewhere in their title; however, again it is important to drill down into the portfolio as each fund is likely to have a different focus.
For example, despite its title CIS Sustainable World has most of its holdings in large multinational corporations not known specifically for their contribution towards sustainable or environmental issues.
These include pharmaceutical giants AstraZeneca, Novartis and Roche, alcohol manufacturers SAB Miller and Diageo, Lloyds and HSBC banks, controversial retailers Amazon and Starbucks, and media conglomerate Walt Disney.
In contrast, most investors would be hard-pressed to recognise many of the holdings in WHEB Sustainability's portfolio, which is populated by small and medium-sized firms involved in areas such as energy-efficient lighting and building insulation, clean energy and water, and health and education.
Seb Beloe, partner and head of sustainability research at WHEB Asset Management, says that this approach means the fund only invests in companies making positive contributions to society or the environment. It also naturally excludes firms in sectors traditionally seen as unethical, as very few, if any, would meet the fund's investment criteria.
'WHEB Sustainability is entirely focused on companies providing solutions to sustainability challenges; so every company that we invest in has a product that is addressing a critical social or environmental challenge. There are no oil and gas companies, there are no banks, there are no retailers and there are no insurance companies,' explains Beloe.
Many sustainable and environmental funds also have a strong emphasis on corporate engagement, or on actively working with a company to improve its practices and processes. These include Alliance Trust Investments' Sustainable Future range, managed by Peter Michaelis, Simon Clements and Neil Brown.
According to Michaelis, engagement is one of the pillars of his team's investment process. 'We aim to deliver strong investment returns by investing in sustainable companies. Secondly, we aim to use our influence to engage with companies to improve the way they operate. This is what our clients are most interested in, so we take engagement very seriously,' he says.
Beloe also says that engagement is one of the key issues for investors in the WHEB Sustainability fund. The firm produces a quarterly report on its voting and engagement activities. As well as satisfying clients, Beloe adds that engagement with the companies WHEB invests in ultimately leads to better returns.
'Engagement is something the market is being encouraged to do with the stewardship code, although a lot of investors see it as a tick box. We, however, see engagement as a way of understanding companies better and, therefore, being able to make better investment decisions, although you do need to have a relatively long holding period,' he says.
IDENTIFY WHAT YOU WANT TO INVEST IN
The key to making the right ethical or sustainable investment decision is identifying exactly what it is you do and don't want to invest in. If you simply want to exclude the main sin sectors, a traditional ethical fund may suffice; if you would rather invest in companies making active positive changes, a sustainable fund may be better suited.
For those with portfolios large enough (typically in excess of £100,000), a specialist ethical and sustainable financial adviser such as Barchester Green may be the answer. The Ethical Investment Association, a coalition of financial advisers from around the UK, has a search tool on its website ethicalinvestment.org.uk which allows you to search for your local specialist adviser.
There are, however, a number of online tools available for the self-directed investor. These include yourethicalmoney.com, which lists ethical, sustainable and environmental funds in the UK in a handy table that shows the main issues each fund addresses.
Another online resource that contains a number of ethical and sustainable investing guides, as well as the latest news from the industry, is blueandgreentomorrow.com.
A number of new initiatives aimed at making the process of identifying the right ethical or sustainable fund easier for private investors are also in the pipeline. These include sriservices.co.uk, a website that breaks down ethical and sustainable investing into seven distinct categories.
Alternatively, investors can take a questionnaire at stylefinder.fundecomarket.co.uk to work out their ethical and sustainable priorities. In May founder Julie Dreblow will be adding a fund-finder tool, designed to match investors to funds based on the criteria they enter.
Simon Leadbetter, founder of Blue and Green Tomorrow, is launching a fund platform through Alliance Trust Savings: alliancetrustsavings.co.uk/blue-and-green.
As with SRI Services, the platform will allow investors to filter ethical and sustainable funds based on their desired criteria, with the added feature that they will be available for purchase directly on the platform. Leadbetter plans for the site to be fully operational by September.
Identifying the right fund to match your principles will take a little extra work, but if you are passionate about making a difference through their choice of investments it is likely to be a small price to pay.