Not all ethical funds are created equal.
Ethical funds come in many shapes and sizes. They can have fundamental differences in the way they are constructed. The main strategies employed by ethical funds are as follows:
(1) Negative Screening
Historically, these funds would use strict criteria to screen out certain industries and negative activities they wish to avoid. Common issues include: Weaponry or nuclear, Human rights, alcohol production, pollution, animal testing, fur products, pornography, tobacco, and gambling.
(2) Positive Screening
In more recent years, ethical funds have introduced a different type of criteria known as ‘positive screening’. In this way, they tend to favour companies that are involved in activities that benefit society and the environment. Common areas include: human rights, local communities, ethical employment practices (e.g. equal opportunity, anti-discrimination policies), environmental protection measures (e.g. pollution control, recycling), anti-bribery and corruption.
(3) Sustainable investing
Sustainable funds can be argued to be a form of positive screening but they deserve to be discussed here separately. Their similarities are that invest in companies that are likely to have a positive impact on society as well as the environment. However, they tend to be more forward-looking and assess companies on how well they are likely to perform in light of certain future trends.
These funds may have certain ‘sustainable themes’ which they would like to support and will favour those businesses that are best positioned to take advantage of a shift towards these themes and new practices. Examples include changing demographics (e.g. the UK is an ageing population so these funds could be very interested in the healthcare sector for instance), natural resources (e.g. renewal energy), climate change and also changing regulations.
These funds open up new avenues for investing that cannot be achieved through traditional ethical funds. The effect is that they allow the fund manager to create a more diversified portfolio with lower overall risk akin to an ordinary, unconstrained fund.
Fund managers that adopt an active engagement policy will use their influence as shareholders to bring about change from top-down by challenging them to achieve higher environmental, social and governance (ESG) standards.
Typically, engagement takes the form of face to face meetings, running seminars, writing reports and lobbying senior company executives. As shareholders in the company, ethical fund managers can also regularly exercise their votes at AGMs.
Engagement funds are ideal for investors who want to encourage companies to be more responsibly managed rather than simply avoiding the issues altogether. In this way, these funds tend to offer better diversification across a broader range assets.
Which type of ethical strategy is better?
In practice, most funds tend to use a combination of the above strategies. When we build our Ethical portfolios for clients, we aim for a range of these funds so that we can get the best of all practices. The result being a diversified portfolio to lower the overall risk.
Are ethical investments inherently riskier?
The short answer is yes. Allow me to explain…
It is widely accepted that there’s a strong correlation between risk and reward. Generally speaking, the higher the level of risk you take, the greater the potential rewards. The reverse is also true – the lower the risk you take, the lower potential of your rewards. There is no such thing as a low risk, high reward investment.
It is also a well-known fact that diversification can reduce risk. Diversification is a technique that is used to spread your investments across a mix of different assets (such as shares, property, bonds, cash, alternatives etc.).
By applying an ethical ‘filter’, you will screen out a large number of ‘non-ethical’ investments. By its very nature then, an ethical fund will lack diversification when compared to an unconstrained fund. The result is that you can end up with a higher risk fund but without the corresponding level of higher rewards.
It is also evident that a large number of Ethical funds have a natural bias towards the UK, so geographically it may not be as well-diversified when compared with its unscreened counterpart. The combined effect is that you may see greater ups and downs (volatility) particularly in shorter term. In the long term, however, there may not be too much difference in terms of performance.
It can be argued that socially responsible companies may prove to be better financial investments in long run. The rigorous screening process within an ethical fund can help to identify companies that, in the long term, have a great potential to do well.
Some Ethical funds can also be biased towards smaller and medium sized companies which are often higher risk but can be an advantage as they provide significantly greater capital growth in the long term.
Furthermore, there are a growing number of quality Ethical funds in the market, which means that it is possible to build a balanced portfolio that can provide a good level of overall diversification to suit whatever your risk appetite may be.
IFS Wealth & Pensions Chartered Financial Planners
As Independent Financial Advisers (IFAs), we are well positioned to advise on Ethical investments. We are not restricted to the funds we use and can search the whole market to build a suitable portfolio for you. We have a growing number of clients who are ethical investors and have been advising in this market for many years.
Whether you have a pension, an ISA, an investment bond or an alternative product, we can review them to ensure they are invested ethically and aligned to your preferences.
IFS Wealth & Pensions has attained Chartered status, awarded by the Chartered Insurance Institute, which is the gold standard for IFAs. Less than 5% of advice firms are Chartered so you can be sure that the advice we provide is of the highest standards.
It’s important to bear in mind that the standard caveats to investing apply. In particular, the value of investments can go down in value as well as up, so you could get back less than you invest. Past performance if not a reliable guide to future performance. The aim of this article is to provide general information only and should not be taken as personal advice based on your circumstances. If you are unsure of how suitable an investment is for you, please seek personal advice from our Independent Financial Advisers.