Are ethical inflows here to stay?

Ethical funds have been growing in popularity recently, as prominent funds net outsized returns and diminish the view that ethical means taking a haircut on performance. 

Morningstar data shows around £12bn sits in UK domiciled ethical funds, although the research group’s ethical designation is fairly broad brush. 

Data collection on the space is not easy as most data houses have no specific ‘ethical’ sector or categorisation. Instead Morningstar flags certain funds as ethical, but which span the range from light touch, or light green, through to more restrictive – so-called dark green funds. 

The increased interest in the funds has seen data providers respond with additional information. FE has created the FE Invest Approved Ethical Funds list of 13 funds that perform well and stick to their ethical and SRI objectives, while Morningstar will be ranking all funds for their underlying ethical, social and governance rating. 

“Our ethical fund has had a lot of inflows. People are more interested in ethical investments, and the fund performance has been very, very strong in its peer group,” says Richard Marwood, portfolio manager for UK equities at AXA Investment Managers and manager of the Axa Ethical Distribution fund. 

A glance at the performance figures for ethical funds make it easy to see why investors are moving into the funds. 

According to Morningstar’s broad ethical categorisation, 66 per cent of the 81 ethical funds listed have outperformed their sector peer group in the past year, with 43 per cent in the top quartile of their peer group. 

The story is similar over the past three years, when 66 per cent outperformed their peers and 32 per cent were top quartile. 

“I think it used to be a question of performance versus principles,” says Muna Abu-Habsa, senior analyst at Morningstar. 

Where previously ethical considerations were viewed as secondary or irrelevant to most investors, they are now viewed very differently today, she says. Rather than just appeasing ethically-conscious people, ethical funds now have an edge over non-ethical rivals as they are investing in more sustainable businesses over time, says Abu-Habsa.  

“It’s become about value as much as values,” she adds. 

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But what has led to this recent outperformance? 

The fall in commodity markets, particularly in the oil price, has helped many ethical funds, which typically don’t invest in such resources, says Abu-Habsa.

“Resources, which most of these funds avoid, have had a tough time recently. That’s been a tailwind where in previous years it has been a headwind,” she says. 

For Audrey Ryan and Iain Buckle, who manage the well-performing Kames Ethical Cautious Managed fund, their restrictions on investing in certain areas of the financial space have pushed them to retail banks, challenger banks and life insurance firms, which have delivered good returns recently. 

More funds have also moved from having strict restrictions to softening them, which has widened their investable universe and boosted returns for some. 

“The negative screening trend is a bit in the past, more managers have a more positive approach to positive contributions to the environment and highlighting companies that are doing great,” says Charles Younes, fund analyst at FE.

But equally ethical funds have had headwinds recently. Kames’ Ryan says the screens on the fund mean it cannot invest in pharmaceutical companies of any nature, which has hampered performance potential. 

“We are clear and explicit on our view on animal welfare and testing, so we cannot invest in pharmaceutical companies. Not being able to invest in that space has been a real performance headwind,” she says. 

The inflows into well-performing ethical funds have given some managers jitters. 

Steve Kenny, director of wholesale at Kames Capital, says the cautious ethical fund has seen a large pick-up in assets recently, but he has some concerns investors are not genuine ethical investors, and instead just chasing returns. 

Kenny says his team is now calling investors and advisers who want to buy into the fund and ensuring they understand that the fund has ethical filters and so therefore will not outperform in all markets. 

“We take very, very seriously our role and resources in speaking to new clients and make very, very clear to them under what circumstances this fund typically underperforms,” says Ryan. 

Performance is not the only factor driving inflows, says Younes. 

“I think the adviser industry is growing and more financial advisers want to invest in ethical funds. I think it’s more like a trend within the political landscape in the UK, where people want to invest ethically more than it being a performance story,” he says. 

Ryan agrees: “My view is that there is definitely a sense there is greater appetite from the average mainstream investor to be invested ethically or giving it some form of consideration.” 

But the increase in interest in ethical funds has not led to a surge of launches from asset managers. 

Morningstar data shows that Alliance Trust was the only manager to launch new funds in 2014, with the Sustainable Future Cautious Managed and Defensive Managed funds. Before that, the previous launches were in 2012, of the Rathbones Active Income and Growth fund, First State Worldwide Sustainable fund and the Alliance Trust UK Ethical fund. 

“I was surprised, I expected more funds to be launched over the past two to three years and that actually didn’t really happen,” says Younes. 

What has developed in the market is more specialist funds, says Younes, and this may be where we see more fund launches. For example, he highlights the Pictet Water fund and the BlackRock New Energy fund. 

“Performance in these funds has been generated based on stock selection, previously global equities funds had a top down approach and didn’t do very well on performance,” he says. 

However, one hindrance to these launches is the very specialised manager knowledge needed, says Younes. 

But with the cyclical nature of ethical funds, managers are braced to see how much of recent inflows will stay patient through periods of underperformance. 

While the sales team have made clear the nature of the fund and that the “screen means there will be times we do well and do really badly,” says Ryan. “Loyalty of clients in this fund has never been tested until a period of bad performance, which undoubtedly we’ll have at some point.”