Ethical funds have a long way to go
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Sarah Coles, Fund Strategy contributorEthical investing is supposed to have crossed over from its hippy heartland. Dark or light green funds are a regular fixture among pension investment options, and a survey by Friends Provident in June suggested more than half of all people think ethical investment is more important than 25 years ago.
So why are these funds conspicuously absent from the Adviser Fund Index (AFI) selections, in all three portfolios?
The major excluding factor is that advisers are simply not seeing this reported interest translated into demand for ethical funds. It continues to be a minority interest, which has not seen any striking trends in recent years.
Tim Cockerill, the head of research at Rowan Capital, says: “The number of enquiries we get are fairly limited; we are not getting any more or any less.”
The official figures would seem to back this up, as ethical funds have consistently made up about 1% of funds under management for about 10 years. Advisers are therefore not likely to include funds simply because they feel an ethical fund should be there.
Darius McDermott, the managing director of Chelsea Financial Services, says: “With AFI we only pick our 10 most favoured funds, and the argument for including an ethical fund isn’t compelling enough.”
Therefore, the only basis on which they would be included is if they were performing exceptionally strongly.
Unfortunately, ethical funds are falling short here too.
Graham Toone, the head of investment research at AFH Independent Financial Services, says: “Performance is the main reason we don’t have any of these funds in the portfolio.”
Mick Gilligan, the head of research at Killik, agrees: “We would look at funds in terms of their individual merits. If an ethical fund happened to meet our requirements we could include it, but at the moment they are not.”
The performance problems are largely the result of the restricted investment universe, which means funds cannot necessarily hold the best-performing stocks.
Hilary Coghill, chief investment officer at City Asset Management, says: “During the boom they couldn’t take full advantage of the boom in commodities because they couldn’t hold companies like miners.” Instead many of them held consumer cyclical stocks, banks and housebuilders, to buy into the growing economy.
This, unfortunately, had a sting in the tail. Coghill says: “A lot of ethical funds had quite high weightings of banks last year, and many were caught out in the downturn holding consumer stocks and housing.”
McDermott says there is an additional reason for disappointing performance: “Ethical funds screen out certain kinds of stocks, including tobacco, military and sometimes oil companies. This means in many cases large companies are screened out, so these funds have a small and mid cap bias.”
Last year was terrible for smaller companies, which were down about 50% from the peak, and ethical funds suffered accordingly.
They were also unable to hold many of the defensive stocks that have performed well in the downturn. Toone says: “At the moment people are looking to tobacco, pharmaceuticals and oil. You don’t tend to get those stocks in ethical funds.”
The funds have done reasonably well in the rally of recent weeks. McDermott points out that small and mid caps have bounced considerably from the lows. However, he adds: “They had been so oversold that there was a rally, but they are still way down from the peak, and this doesn’t constitute a recovery.”
Likewise, housebuilders have contributed to the upside recently. McDermott says: “Housebuilders were priced to go bust back in the spring, so when they didn’t go under, they rallied, which helped ethical funds with a holding. But this isn’t a vote of confidence for the sector.”
Ethical funds struggle with performance, and cannot make their mark on principle alone. They are unlikely, therefore, to have a major place in the AFI for the foreseeable future. But the advisers are not writing them off. Many like the concept, and are waiting for a fund that combines it with consistently strong performance. Some hold out hope that environmental themes may bring outperformance to ethical funds in the long term.
Another positive indicator for the future is that, as Cockerill says: “Their investment universe is getting bigger, as corporate governance becomes integrated across more industries.”
Indeed, as companies clean up their acts ethical funds will have more potential stocks to pick from, so they have better access to the outperformers. “In a volatile market, fund managers need to give themselves the flexibility to invest in stocks with the potential to perform,” Cockerill adds.
With fewer restrictions on the investment universe, ethical funds could see better performance, and consequently more interest from advisers for mainstream portfolios.
However, this is not going to be an overnight sensation. More than half of people may feel that ethical investment is more important than back in the 1980s, but they are still a long way from acting on that view.
