Moral maze for ethical investors: Funds that avoid 'immoral' targets have performed well recently, but Richard Thomson asks whether such a high-minded stance in the business world is really more than a marketing ploy

THE FURORE over Body Shop was probably inevitable. Franklin Research and Development, a US fund manager based in Boston, sold shares in the company last week, partly because of its concern over Body Shop's famous green and ethical image. That image, it feared, might be less than accurate.

Body Shop's critics rose up to claim yet again that the company was failing to live up to its high ideals. Body Shop, meanwhile, furiously defended itself with more than a hint of desperation. 'No one should doubt our commitment,' declared Gordon Roddick, the chairman, in a letter to the Financial Times last Wednesday. 'We will continue to develop our business with the highest ethical principles.' If critics could not accept the company's high ideals, 'that's their problem, not ours,' he added.

In truth, however, it is Body Shop's problem. The company, under the forceful leadership of its founder, Anita Roddick, has based itself on a high-minded philosophy of ethical business. It is concerned with protecting the environment, not testing products on animals, a 'trade- not-aid' policy of helping native producers of some of its more exotic products. A business, says Mrs Roddick, is not there primarily to make profits but to behave responsibly in the community.

This philosophy is Body Shop's selling point, the foundation of its advertising and publicity. Should it turn out to be seriously tainted - an article in the US magazine Business Ethics to be published this week is expected to come up with damaging criticisms - Body Shop would be exposed as a sham.

Yet Body Shop is one of the very few British companies that has dared to base its appeal on such potentially treacherous ground as ethics. The Co-operative Bank is perhaps the only other to make a similarly overt ethical appeal, with its promise - among others - not to lend to repressive foreign regimes.

Most companies, though, are still grappling with the more familiar business realities of dividend increases and shareholder value. BAT Industries, the tobacco giant, typifies the traditional view. 'We're here to create wealth for our shareholders,' said Michael Prideaux, director of group public affairs. BAT is unrepentant about selling cigarettes and refuses to accept that tobacco causes cancer. It sees its job, purely and simply, to make profits.

'What is the investor asking himself? He is asking, 'will this stock make money?' Over the long run we've been able to answer that very favourably,' said Mr Prideaux.

To a tiny but rapidly growing portion of the investment community - ethical funds , representing under 1 per cent of total UK investment funds - BAT is regarded as something like the devil incarnate. Not only does it sell a carcinogenic drug for profit, it sells much of it to the Third World - an area particularly dear to the hearts of ethical investors. To them, BAT typifies the greedy and socially irresponsible excess of capitalism that should be shunned.

The first attempts at ethical investment were the funds managed by the Church Commissioners, which achieved patchy success in avoiding unethical investments. But it was the Americans who popularised the idea with 'single issue funds' - those which did not invest in, say, South Africa, tobacco or alcohol.

This approach kept the ethical decisions simple and clear- cut. In Britain, however, the ethical funds have adopted a more complex and potentially confusing approach. The 'ethics' espoused by these funds often seem to be a somewhat incoherent collection of the latest fashionable attitudes, in which rain forests and kindness to animals play a leading role. Inevitably, this has fuelled criticism from some quarters that such funds are really little more than a new angle for marketing more investment vehicles to a well-meaning but somewhat naive public.

The first lay fund in the UK was launched by Friends Provident 11 years ago in deference to the high principles of its Quaker roots. It proved unexpectedly popular. The fund expected to garner no more than pounds 5m in investments in the first three years, but within a year, pounds 10m had flooded in. With pounds 400m under management, Friends Provident's Stewardship funds now make up about half the ethical sector, although a total of 31 unit and investment trustshave come into existence.

But what is an ethical investment? Body Shop, with its self-conscious policies and the wealth of information it provides about its efforts to live up to its ideals, is an obvious candidate for inclusion in such funds. But few other companies are such a clear-cut choice. 'No company is perfect,' said Peter Webster, at the Ethical Investment Research Service (Eiris), which attempts to calibrate the saintliness of Britain's quoted companies. 'Ethical investors are looking at UK stocks and doing their best with what's there.'

Most funds agree on several criteria. They do not like companies that make and sell arms, tobacco and alcohol, that test cosmetics on animals, publish pornography, devastate rain forests, disrupt native communities, or cause pollution. Some disapprove of companies that make political donations, lend money to dictatorships, produce shoddy goods or mistreat their staff.

The range of ethical considerations is often bewilderingly wide and sometimes frankly arbitrary, which raises questions about just how valuable such 'ethical' judgements are.

Some funds, such as Scottish Equitable, apply their criteria negatively. It completely avoids companies involved in meat production and processing, making it a strictly vegetarian fund. In other areas, however, it is less stringent. Any company, for example, that gains more than 10 per cent of its revenue from tobacco, drink or gambling is beyond the pale.

Taking the opposite approach, the TSB is one fund that looks exclusively at positive criteria. Fronted by David Bellamy, the enthusiastic TV botanist, the fund takes the view that large companies have created most environmental mess, so those doing the most to clean it up should be encouraged.

But in a survey last year, the Consumer Association's magazine Which? was unimpressed at the way many funds managed to implement their declared policies. 'Just because a fund calls itself ethical or environmental doesn't mean it avoids all the areas you might expect,' it warned. It found that Abtrust had invested in Weir Group, which makes the launching systems for nuclear submarines. TSB invested in Unilever, which tested cosmetics on animals. Some funds invested in countries with repressive regimes condemned by Amnesty International, while few avoided the ethically controversial area of intensive farming.

Investors are likely to be most confused by funds, such as Friends Provident, which take both negative and positive approaches in a highly complex process of selection. While generally excluding the likes of British Aerospace (weapons) and BAT (tobacco), it refuses to be rigid.

'We don't have absolute exclusions - a company may do some good which may outweigh the bad,' said Peter Sylvester, manager of Friends Provident's ethical funds. 'We could, for instance, just cross off all companies on the Ministry of Defence supply list, but it's not that simple. We found one company that was producing an electronic component which went into missiles. But before crossing it off our investment list, we found that the same component went into all sorts of ordinary household appliances. So we kept the company on the list.'

When it comes to positive criteria, the selection process becomes more tortuous and even distinctly odd. 'We look at companies that have good management practices - such as equal opportunities - and which treat their staff and customers well.' Meanwhile, Marks and Spencer scores highly for its policy of accepting returned goods and clothing and feeding its employees.

'We also choose companies that produce good products and services that communities want,' said Mr Sylvester, mentioning fire extinguishers. 'Nu- Swift make good fire extinguishers. Everyone needs them, they are useful protection.' As an example of 'bad products', he focused on 'things of poor quality that fall apart. Things like toys that choke kids.' Although Rupert Murdoch's News Corporation is excluded from Friends Provident's list of approved investments, Mr Sylvester said this was not because of the Page 3 nudes in the Sun, who did not qualify as full-scale pornography.

While investment policies such as these no doubt contain a large measure of commercial sense, it is debatable how much they have to do with ethical choices. Naturally, the fund managers fiercely reject any suggestion that their funds are simply another marketing ploy by the investment industry to interest the public in new funds.

Yet the Co-op Bank, like Body Shop, is quite blunt about its use of the ethical issue as a marketing tool. After polling 30,000 of its customers, the bank introduced its ethical code in 1992 and has used it in its advertising ever since. 'We are a bank and have to make a profit,' said a spokesman. 'The ethical policy is a way of differentiating ourselves from other banks.'

The policy itself, which represents the main bugbears of its customers, is a strange hotch- potch. The Co-op promises not to lend to repressive regimes. But as its international lending is virtually non-existent, the likelihood of its ever doing so in the normal course of business was always minimal. It promises not to speculate against the pound with its own money on the grounds that 'it is inappropriate for a British bank to speculate against the British currency' (although customers who wish to convert their own funds out of sterling may do so).

Has this high-mindedness not damaged the bank's profitability by limiting the scope of its business? Not at all, according to the spokesman. 'We lost a few accounts at the beginning, but it appears to have brought in a lot more customers since then.'

The investment funds similarly claim that their selectiveness has not damaged their performance. On the face of it, the restriction on their choice of stocks should lead to lower returns - the inevitable pay-off between conscience and profit. The restrictions, after all, are often severe. Friends Provident can find only 400 quoted stocks it feels comfortable about buying, while Scottish Equitable allows itself a choice of only 250. Of the top 100 companies - the staple diet of most ordinary institutional investors - many ethical funds are happy with a mere five or six, leaving a preponderance of smaller companies in their portfolios.

To avoid selecting themselves out of the market altogether, the funds have to make compromises. A fund such as Scottish Equitable will invest in companies that derive less than 10 per cent of their revenue from arms, drink or tobacco. But why, if such activities are wrong and the fund is serious about its principles, should it invest in such companies at all? 'Because you'd rule out too many companies,' explained Charles Henderson, the unit trust marketing manager. 'It's a commercial decision.'

But despite restricting their range of investments, the ethical funds perform remarkably well (see table). According to Micropal, which monitors unit trust performance, the ethical sector over the last five years has comfortably outperformed both the UK income and UK growth funds.

Ethical fund managers seem a little uncertain about why this should be. Peter Sylvester thought it might be that because of the depth of research carried out into each company to discover their ethical qualifications, the funds came to know them very thoroughly as businesses. 'Anyway,' he added, 'We are looking for companies with good managements and good products, which is only sound investment practice.'

Which all suggests, as Body Shop has been proving for years to the annoyance of its critics, that ethical high-mindedness can be good for business. It is, unquestionably, good marketing since there is an obvious and growing demand among the public for a greater sense of conscience in investment and business in general. The Co-op Bank has made good advertising out of it, and the ethical funds have created a new niche in the investment industry on the back of it.

In short, ethics sell. But if evidence emerges that Body Shop has not been living up to its ideals, the ethical sector will suffer a heavy blow. It will certainly come as no surprise to those who believe that it is just so much marketing hype.

----------------------------------------------------------------- Ethical unit trusts beat the market ----------------------------------------------------------------- Performances show value of pounds 100 invested in August 1989 on an offer to bid basis with net income reinvested Performance Fund size ( pounds m) Abbey Ethical 142.22 23.20 Abtrust Ethical - 1.22 Acorn Ethical 145.46 4.00 Allchurches Amity 126.47 19.21 CIS Environ - 29.58 Clerical Med Evergreen - 17.40 Credit Suisse Fellowship 106.15 5.49 Eagle Star Environmental 157.05 14.24 Equitable Ethical - 15.08 Framlington Health 224.64 9.60 Friends Prov Stewardship 127.83 166.32 Friends Prov Stewardship Inc 120.61 50.05 Friends Prov Stewardship N Am 147.11 4.93 Jupiter/Merlin Ecology 128.99 13.53 NM Conscience 139.00 14.43 NPI Global Care - 9.80 Scottish Equitable Ethical 129.90 14.50 Sovereign Ethical 117.61 8.47 TSB Environmental Investor 136.70 21.40 United Charities 147.58 2.56 Sector average 139.82 UK equity growth 127.06 UK equity income 135.44 ----------------------------------------------------------------- Source: Micropal -----------------------------------------------------------------

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