Helen McGill looks at how the ethical investment market has developed over the years and the various ethical investment styles available
Which shade of green suits you: dark or light? For potential ethical investors, this is not merely a question of aesthetics, but a matter of personal beliefs and financial goals.
Dark green funds are the stricter type of investment, ideal for people with strong convictions about corporate activities they oppose. Such activities range from arms manufacture and animal testing to the sale of tobacco and production of pesticides. Fund managers screen potential holdings against negative criteria and exclude companies whose behaviour is deemed unacceptable.
Light green funds, on the other hand, employ positive standards for selecting stocks. Taking a more pragmatic approach than the exclusionary dark green method, these funds choose potential holdings on the basis of positive actions or their status as 'best of class.'
To illustrate the difference, oil giant BP Amoco would probably be excluded from dark green ethical funds because the generation of fossil fuels is viewed by many as harmful to the environment. However, the company is a likely holding for the lighter variety because its environmental policy and solar power division make it the 'best of sector.'
Over the last decade, the ethical investment trend has moved toward the lighter variety, but there is something for everyone among the funds available.
The lively market now is a far cry from the handful of funds available during the 1980s. During the 'Me Decade' the general public and many financial institutions perceived ethical investors as eccentrics, zealots or tree-hugging hippies. As a result, ethical investment remained on the sidelines of the UK market, and many fund managers failed to take it seriously.
This view gradually lost steam as public awareness of social and environmental issues grew. Increasing media coverage and the rise of the Internet helped to put issues such as climate change, animal testing and globalisation into the mainstream consciousness.
Pressure groups like Friends of the Earth (FoE) also became more powerful and, at the same time, governments began to respond to demands for change by using the tools at their disposal: legislation and tax.
In the UK, legislation came into force on 3 July 2000 requiring pension fund trustees to disclose how, if at all, they take account of ethical, social and environmental issues in their investment strategies. This alone promoted interest in ethical funds, particularly of the light green sort.
Follow your conscience
All good fund managers will lay out in detail the basis on which they select their holdings. No two portfolios have the same criteria, so it is important to make sure they gel with your own. Some funds focus on human rights, while others concentrate on the environment, and still others put animal welfare at the core of their strategy.
It is also important to know how fund managers go about determining whether a company will pass muster for either a dark or light green fund. Particularly for the former, many fund managers use the Ethical Investment Research Service (EIRIS). Set up in 1983 with the help of churches and charities, EIRIS independently researches corporate behaviour. It does not offer financial advice or investment management services but weeds out companies based on criteria set out by the fund manager. In addition, a small number of investment houses have in-house research teams to do the legwork for both types of ethical fund.
In terms of the light green category ' now commonly known as socially responsible investment (SRI) ' fund managers have three ways in which to implement this more flexible approach.
The first method is positive screening, in which managers choose holdings that demonstrate positive criteria covering the environment, human rights, social welfare, corporate governance and animal welfare. Potential candidates range from companies developing renewable energy technologies to those that sell fair trade products such as coffee. Most light green funds will use this method in combination with a small number of negative criteria to maintain the ethical integrity of the fund.
The second approach is preferment ' choosing the 'best of sector.' This style of investment, employed by a few managers, allows shares to be chosen from industries or sectors that would normally be off-limits in a dark green fund.
A third approach to SRI is engagement, the primary purpose of which is to encourage companies to adopt best practices and policies. In this vein, fund managers and/or their ethical research teams meet with the management of potential and current holdings to find out about company policy, discuss issues of concern and identify ways of improving their business activities. The outcome of these meetings and further research determines whether the company will be added to, or kept on, the roster.
Shades of difference
So, the light and dark green approaches are decidedly different. What are the advantages and disadvantages of each?
The most obvious benefit of dark green funds is the moral one. People with strong ethical beliefs want to know that they are not making money by exploiting humans, animals or the environment.
This type of investment can meet that need. In addition, this variety gives investors the opportunity to support companies that have similar social and environmental views. However, the trade-off to being ethically watertight can sometimes be underperformance.
Dark green funds tend to exclude the largest companies in the UK, financials, pharmaceuticals, utilities and tobacco companies, and these often provide the greatest gains.
In addition, being confined to a narrow range of investment opportunities hampers diversification and thus increases risk. As a result, these portfolios are volatile and hard-pressed to match the performance of indices against which they are measured (such as the FTSE All-Share).
This may not matter so much to people who favour dark green investment precisely because it is strict. But critics of pure negative screening make another point: this method does not allow for constructive interaction with mainstream companies.
Enter the light green approach, in which engagement plays a considerable role. As ethical investors have come to realise, interaction with company management often achieves results much more quickly than a simple boycott.
One way is to use shareholder voting rights at corporate annual general meetings (AGM) to raise matters of concern. A recent example highlights how UK institutional investors and the public (individuals and organisations) have made the most of their voting rights.
FoE purchased £30,000 worth of shares in Balfour Beatty to make a challenging resolution at the construction company's May AGM. Balfour Beatty is leading a consortium intending to build the controversial Ilisu Dam in Turkey. The proposed dam would displace a large number of people and affect the environment.
While Balfour Beatty defeated the resolution, it failed to win the support of more than 40% of the institutional investors that had cast votes at the AGM. The company also received negative press as a result.
Companies are discovering that they are putting their reputations and their share price at risk by ignoring ethical issues. On the other hand, companies that demonstrate good behaviour are increasingly being rewarded in the markets. SRI funds have the potential to outperform thanks to this shift in momentum.
The broader investment universe of light green funds also offers better potential for outperformance.
Positive screening and 'best of class' stock selection considerably increase the proportion of FTSE All-Share constituents from which fund managers can choose. As a result, investment risk drops and the manager can take greater advantage of market trends. For example, if pharmaceuticals and financials enjoy a period of strong performance, light green funds would be able to derive some gains from that.
Finally, the more flexible light green approach allows investors to support companies that are making a positive difference, perhaps encouraging other firms to follow suit.
That said, critics argue that the fluid criteria of some light green funds justifies investments that would otherwise be off-limits. Best of class selection comes under particular scrutiny, as certain sectors (such as industrials and oils) have activities that are harmful to the environment as their core business.
In the end, light and dark green funds offer the opportunity to work towards social good while making financial returns. As for which suits you best, look in the mirror and find out.
l There are two major types of ethical investment: light green and dark green.
l Dark green funds tend to exclude the largest companies in the UK.
l Being confined to a narrow investment range can increase risk.
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