Personal Finance: Money & Ethics: Can morals make a return?

In the second of his series on ethical funds, Iain Morse looks at how screening out stocks can affect a portfolio's profits

Anyone choosing to invest into an ethical fund makes a moral decision to avoid some business activities and perhaps support others - but also wants a return on their investment. The question for fund managers is how to deliver those returns while still maintaining an ethical stance.

This isn't always an easy task, given the different definitions of what is ethical and what is not. Despite a common label, ethical funds can differ widely, both in terms of which shares they will or will not hold and in how they see their relationship with companies they invest into.

Investing ethically can also involve other dilemmas. Running a truly "clean" fund is nigh-on impossible, while the use of positive and negative share selection criteria imposes limitations on fund managers.

Part of the problem hinges on the size of companies whose shares are acceptable to ethical funds. Elaine Morgan, ethical fund manager at Scottish Equitable, one provider, explains: "There's little commonality to all the available funds." But she adds: "Some themes emerge, [such as] a tendency to be overweight in small companies, or avoidance of traditional heavy industries."

The key issue is how far ethical selection criteria distorts the "universe" of possible share holdings in a fund against a model portfolio based on the UK stock market.

Take the FTSE 100 share index, covering the 100 largest traded companies. Each has a market capitalisation of at least pounds 1bn, and together they account for 70 per cent of the UK stock market by value. The next 250 companies, measured by the Mid-Cap Index, account for about 25 per cent of the stock market.

In theory, a model investment portfolio would contain around 70 per cent of its value in the top 100 shares. However, by their nature, large companies are diversified across a very wide range of activities, many with wholly or partly owned foreign subsidiaries, some in joint ventures with other companies, and foreign governments. This means that many large companies will fail one or more negative criteria adopted by ethical fund managers.

There is also the question of risk. From an investors' point of view, risk is as much about short-term fluctuations in value as long-term fund performance relative to a benchmark like the FTSE AllShare index. As a rule, small company shares are more volatile than those of the top 100.

When selecting an ethical fund, its use of screening and investment philosophy will tell you where it stands on the risk spectrum.

At one end of the scale is the fund applying a full range of negative screens on companies, and then selecting only those companies which satisfy further positive criteria. One run in this way might select no more than 20 per cent of FTSE 100 shares, and will have a high exposure to small company shares.

Centre of the scale are funds applying a limited set of negative screens, but pragmatic in their approach to particular companies. If management gives a positive response to criticism, or are "best in their class", their shares can be included in the portfolio.

This approach, taken by both Friends Provident and NPI, allows about 40 per cent of the FTSE 100 share index to form part of their portfolios, with a consequent reduction in risk. About half of each company's funds consists of FTSE 100 shares.

At the other end of the scale are funds with minimal negative screening, but which talk to companies on a range of issues - pollution is a favourite - trying to encourage them to change their ways. At this end, as much as 80 to 90 per cent of a fund's value may be in large companies.

One way to measure fund risk is by their volatility, or the extent to which their returns vary month on month over a number of years. The greater the volatility, the riskier the fund.

Jeff Saunders, chief investment manager at Standard Life, believes: "By their nature, ethical funds must be more volatile than mainstream UK equity funds. I'd compare our fund to the UK small companies sector.

"Consensus expectations of change on matters like pollution regulation are already factored into the market. We use screening which separates shares into three groups: unacceptable, acceptable, and preferred." Standard Life, like many other fund managers, uses screening provided by the Ethical Investment Research Service (Eiris).

Some companies go further. Anne-Maree O'Conner, head research analyst at NPI, says: "Negative screening does nothing to promote real change. It's a thing of the past. The point now is to influence management."

NPI does all its research in-house, she adds. "It's easy to launch a new ethical fund, using one or two negative screens, and use this as a marketing ploy. But we try to use our influence more deeply, taking a holistic view of companies we invest into."

`The Independent' has produced a free 28-page `Guide to Ethical Finances', written by Nic Cicutti, the paper's personal finance editor, and sponsored by Friends Provident. Call 0800 214487 or fill in the coupon on page 3.