Best green funds balance ethics with results

How many reasons does it take to realise that ethics matter? Is it the financial crisis caused by the reckless behaviour of highly paid investment bankers; the scandal of mis-selling of payment protection insurance and interest-only mortgages; or the blatant manipulation of the Libor lending rate?

Is it the sight of the more than 1,000 Bangladeshi workers buried under the rubble of their substandard factory producing clothes for Western high streets; or the gaping holes in our food supply chain that allowed horsemeat to masquerade as prime beef?

Perhaps it is the growing evidence that climate change is increasing the incidence of catastrophic weather events, whether floods on our own small island or droughts and tornadoes elsewhere? Or is it the tax avoidance by global companies, from Starbucks to Apple; or the fines for mis-selling drugs by some of our leading drug companies?

Surely even the most laissez-faire of investors must be waking up to the fact that corporate behaviour has financial consequences that will, ultimately, be reflected in profits and share prices.

Retail investors do not seem to have got the message, however. EIRIS, the ethical research specialist, boasts that the amount of money invested in socially responsible investing (SRI) funds reached £11 billion in June 2012 compared with £3.8 billion a decade previously, but that growth rate is roughly in line with that for the funds industry as a whole. And the £11 billion is still just a tiny fraction of the £650 billion value of the UK industry as a whole.

Indeed, the market actually seems to be shrinking: in the past two years, two of the stalwarts of SRI have effectively abandoned the cause. First Henderson Global Investors closed its specialist SRI unit; then last year, Aviva sold its SRI business to Alliance Trust. Aviva Investors' then chief executive, Alain Dromer, said: "These are themes that do not particularly generate any revenues. Funds under management in our SRI funds have been stagnant."

Best and worst ethical fund performers

Yet performance of many funds has been decent, with the best ethical funds doing at least as well as their unscreened counterparts: the top five ethical performers over the past decade - Ecclesiastical Amity International, Kames Ethical Equity, CIS Sustainable Leaders, Standard Life UK Ethical and Jupiter Ecology - are all in the top quartile for their respective sectors and the best, the Ecclesiastical fund, is in the top 10 of the 245 global equity funds.

But there have been some dismal performers too - and, unfortunately for the image of the industry, some of the sustainable or clean energy funds launched in a flurry of climate change enthusiasm in recent years are among the worst. Allianz Global Eco Trends, Pictet Clean Energy and BlackRock Global Funds New Energy have all lost more than a fifth of their value over five years.

This simply confirms that, as with any other type of fund, careful selection of the manager and the investment focus is key. Neville White, senior SRI analyst at Ecclesiastical - whose products include a UK, a European and international equity funds, as well as a Money Observer 2013 award-winningsterling bond fund - says one of the key factors in its record is its long-term approach.

Its managers have been in place for a long time - Sue Round, manager of the Ecclesiastical Amity UK fund, has been running it since 1988 and Robin Hepworth has managed its international fund since 1999. They take a long view: the average holding period of investments in Ecclesiastical funds is between seven and eight years compared with the average across the market of about seven months. Screening is an integrated part of the process, with the SRI team working with the fund managers to unearth sustainable businesses that also have attractive prospects.

Some of the companies the process throws up will be familiar - Vodafone and GlaxoSmithKline feature in the top 10 of both the UK and the international funds - but the biggest two UK holdings are the less familiar Dechra Pharmaceuticals, a veterinary supplier; and homewares retailer Dunelm. The largest holding in the international fund is Singapore-based Ezion Holdings, which develops and charters offshore equipment such as rigs and heavy haul vessels.

"We take a view on the long-term outlook for the company and its sustainability on SRI criteria, so we build a portfolio that integrates the financial case for holding a share and its sustainable credentials," says White. "Taking that holistic view does reduce the risk [of investment] and, because we trade less frequently, the volatility too. We invest in companies we believe in."

While it makes no bones about its ethical credentials, White says it attracts plenty of mainstream investors too: he estimates that the breakdown is roughly 75% mainstream to 25% ethical. He expects firms such as Ecclesiastical to benefit from the withdrawal of some of the larger players from the market.

Long-term investing

Henry Boucher, manager of the Sarasin AgriSar agriculture-focused fund, thinks the exit of some players reflects both the poor performance of the very specialist clean energy funds and the fact that some of the more traditional ethical funds failed to properly marry the SRI elements with the investment return.

"We see ourselves primarily as long-term investors and we have a core philosophical view about stewardship. If you only want short-term performance, you will only be interested in the mechanisms of the market. If you are in it for the long term, your return will come from dividends and from the ownership and stewardship of the business."

The financial crisis, which was effectively caused by the pursuit of short-term returns and beggar the long-term consequences, has led to pressure on investors to take their ownership responsibilities seriously. The Kay Review of UK Equity Markets and Long-Term Decision Making made a number of recommendations, ranging from an end to quarterly reporting to institutional investors taking an active role in the appointment of key board members.

There is evidence of a more general concern about corporate behaviour. Boucher thinks Kay's proposals are a move in the right direction but says the United Nation's Principles for Responsible Investment, a voluntary code for investors, has been as influential. But he admits that some signatories take the practice more seriously than others.

The impact of short-term rather than long-term factors is demonstrated in clean energy. That may be the way of the future, but at present the price of solar, wind and other alternative energy companies is effectively governed by three factors: the price of conventional fuels (which have been falling); the availability of technology (China is churning out solar equipment, so there is a glut of supply); and the willingness of governments to provide subsidies.

Charlie Thomas, manager of Jupiter Ecology, one of the oldest ethical funds in the UK - it has just celebrated its 25th anniversary - says that despite the image of solar as a poor investment, it is proving its viability as an energy source. "Today, in southern Europe and the US, solar is already more than competitive with conventional energy, even without subsidies."

He makes the point that the long-term outlook for renewables remains excellent, with China committed to a more sustainable future. "In China today, 40% of GDP is produced in areas with water scarcity. China gets that and its emphasis is now more on quality growth."

But Thomas adds that investors need to recognise there is more to sustainable investment than simply oil replacement. Key focuses for his fund now are water

treatment, waste management and consumer areas such as food production and security. Among the companies he is keen on are Whole Foods Market, the US-based organic retailer; UK insulation company SIG and French group Schneider Electric.

He thinks the next 25 years will be even more exciting than the past 25. "Renewable energy sources in the UK, for instance, still only account for 9.4% of all electricity generated, organic food makes up just 4.2% of all food sales in the US, while 67% of all waste in the European Union is still dumped in landfills or incinerated. The opportunity for companies to offer transformative solutions to these issues has never been greater."