Money: Investors confront the moral maze

Do we know what we're in for with ethical funds? asks Paul Gosling

Stock market investment and ethics may seem strange bedfellows to some. But there is a growing choice of funds aiming to marry money with moral considerations. The arms industry and companies with bad records for polluting the environment are already commonly blackballed by these funds. And healthcare companies involved in providing abortions are likely to become the next target for an ethical boycott when Standard Life, the Edinburgh insurer, launches its first ethical fund in the spring.

The move into ethical investment by the biggest mutual insurer in Europe and one of Britain's biggest investment managers highlights both the growing importance of ethical finance as well as the controversy over what constitutes unethical activity.

The potential for further growth in ethical finance is reinforced by a survey by Friends Provident, which was the first big insurer to enter the ethical market in 1984. According to the survey, just 16 per cent of people questioned were aware that they could invest their pensions and other savings in funds that choose investments according to ethical as well as financial criteria. But at the same time 93 per cent wanted to invest in ways that "make a profit without anyone getting hurt in the process".

What many ethical investors ignore, however, is that there is no simple definition of "ethical". What is ethically correct to one person will strike horror in another. The suggestion that Standard Life will, unusually, blackball companies involved in abortions (private healthcare companies in the main) adds another strand to this debate.

Investors should be aware that most ethical funds operate on a negative basis of avoiding particular types of activity, rather than actively putting money into things that do good. "Green" funds, on the other hand, will usually not have a general ethical policy, but will focus on companies that have a beneficial environmental impact.

Amanda Davidson, a partner in Holden Meehan, a firm of independent financial advisers that specialises in ethical investments, says investors should think carefully about what they want to achieve. "They must define what is important to them in terms of criteria - is it avoiding animal harm, or armaments, or being positive towards the environment?"

Each ethical fund has a slightly different investment focus and potential investors should pick one that fits them. To obtain information they can consult one of the specialist IFAs, or read Money & Ethics, which examines the approach taken to all the main ethical issues by specialist funds. Beware, too, that investment policy may alter. The Ethical Investors Group, another specialist IFA, is currently in dispute with Friends Provident over the latter's Stewardship Fund. Previously this had not invested in pharmaceutical companies, which carry out tests on animals, but has now bought shares in some smaller companies in the sector. In its defence Friends Provident says that while in the past it has not invested in this industry, it has never had a ban on drug companies.

Much worse, the Eagle Star Environmental Opportunities Fund, a high-performing fund, has just become the first of its kind to close down, and has been merged into a general fund with no ethical or environmental criteria. Eagle Star says that it has done nothing wrong, as it is offering a free transfer out of the fund and it never promoted it as an ethical investment, merely as a green fund offering positive opportunities to invest in non- polluting technology.

Over the last year green funds have generally outperformed ethical funds. This mostly reflects, says Ms Davidson, the geographical location of the underlying investments. The environmental funds have invested internationally but have avoided the emerging markets where heavy environmental damage is taking place and where share prices have fallen badly. Most of the ethical funds have invested in Britain in a period when the US stock market in particular has performed better. Indeed, one of the best-performing ethical funds has been Friends Provident's North American Stewardship Fund. Most of the ethical funds have also trailed the UK stock market as a whole. On its own this should not be seen as proof that ethical investment is a recipe for underperformance, not least as the vast majority of unit trusts of all kinds tend to underperform the market because of charges and less than sparkling investment management. In fact, the debate on whether ethically and environmentally screened funds must automatically give up something on performance remains thorny.

That said, the bias of ethical funds towards smaller companies has led them to miss out on much of the recent boom in share prices. This bias also means the value of holdings in ethical funds tends to be more volatile.

Indeed, this greater volatility should encourage people to question whether an ethical fund is right for them. "There is no point in the ethics being wonderful if there is not going to be a good return," says Ms Davidson. "If you are risk-averse it may not be best to invest in ethicals."

The ethical investment sector is growing strongly, however, and at the current rate is doubling in size every two years. More insurers are entering the market, with both Sun Life and M&G also considering launching ethical products. But perhaps even more so than with other financial products, it is essential to be well advised and to pick the right product.

q 'An independent guide to ethical and green investment funds' is published free by Holden Meehan (0171 692 1700); 'Money & Ethics' is published by Ethical Investment Research Service at pounds 15 on 0171 735 1351.

Independent financial advisers who specialise in ethical investment include Holden Meehan (0171 692 1700); Barchester Green Investment (01722 331241); Ethical Investors Group (01242 522872).

q Next week we look at the smaller green and ethical banks and building societies.

GREEN GROWTH

Comparative performance over five years of top ethical and green funds

Jupiter International Green 183%

Framlington Health 159%

Credit Suisse Fellowship 148%

FT-SE All Share index 115%

Friends Provident Stewardship 115%

Sovereign Ethical 109%

TSB Environmental 107%

United Charities Ethical 106%

Source: Micropal