A marketing concept that locks investors into volatile and substandard returns or the fund strategy for the 21st century? This month's debate is ethical investing
Nick Robins, head of sustained and responsible investment at Henderson Global Investors, makes a case for ethical investments
Sustained and socially responsible investment is the best way to achieve long-term returns, argues Robins. This type of investment has moved a long way since the early days, he says, with anything between 5% and 15% of stock market decisions now influenced by environmental, social or governance factors.
He explains: "The reasons for this are clear and compelling. Issues such as climate change have left the realm of science and become powerful sources of investment risk and opportunity. Hurricanes in the Gulf of Mexico combined with a fatal explosion at its Texas refinery knocked 10% - $2bn (£1.08bn) - off BP's 2005 result, a not inconsiderable amount even for one of the world's biggest companies.
"The flipside is the mounting regulatory incentives, including new programmes from the US to China, which are creating new markets for renewable technologies. After crashing along with other technology sectors in 2001, the value of listed solar companies climbed 11-fold in the three years to the beginning of May 2006 and, despite recent de-risking, the sector offers compound annual growth of 25% to 30%-plus."
Alongside this is rising demand from both individual and institutional investors for a more balanced approach to investment that integrates intangible sources of value and takes a longer-term perspective, says Robins. According to the MORI/Friends Provident 2004 UK survey, 92% of individuals interviewed believe it is important companies take social, ethical and environmental issues seriously, and a further 65% believe financial advisers should ask whether or not clients are interested in investing ethically.
Investment consultants Mercers also found 75% of US institutional investors believe environmental, social or governance factors are material to investment performance and says the risk of climate change should be addressed in investment decision-making.
Robins adds: "In managing ethical, sustainable and responsible investment funds, an in-depth understanding of sustainability trends and responsible business performance provides a powerful insight into an area that is still poorly understood by most market participants. This can also lead to significant outperformance for investors."
There are many ethical themes from clean energy through to health, sustainable transport and water, he says, and fund managers have the choice of more than 4,700 ethical stocks to invest in. Many of these have shown outperformance against the MSCI World on one, three and five-year periods up to 31 December 2005. However, Robins stresses that with any credible investment process, it is essential to take a hard-nosed approach to market analysis and stock valuation and implement tough buy and sell disciplines in order to construct the portfolio.
He says of his own fund: "The multi-thematic approach enables investors to diversify risk and generate returns that are uncorrelated with conventional portfolios. Importantly, while this portfolio is trading at a higher price/earnings multiple to the market as a whole, when looking at the prospective earnings per share growth, it comprises stocks with superior valuation characteristics. In effect, investors in this fund are buying growth stocks at a discount to the market as a whole. As more and more mainstream investors start to recognise and seek this growth, this should push up the prices of these stocks."
Sustained investing and SRI can also be applied to a more value-oriented style of investing, says Robins. However, he believes a different approach is required to achieve good performance for this investment technique - a value style should examine how companies in established sectors are responding to rising expectations of good practice in the marketplace, workplace and the wider community.
According to Robins, not all ethical portfolios are highly volatile or suffer from poor performance. He says: "Conclusions reached by the Association of British Insurers in 2004 show incorporating socially responsible investment in a portfolio can reduce volatility and increase returns. By looking at how socially responsibile investment performed over stocks that are not, in the UK banking sector, the basket of responsible stocks outperformed their weaker peers by 7.8% over one year to the end of April 2006, 19.6% over three years and 10.3% over five years.
"The positive tailwind was even more pronounced in the UK retail sector, where the responsible basket delivered 21.1% outperformance over one year, 84.3% over three years and 74% over five years."
Ethical investing has come of age with rising investor interest and insight
Sustainability themes offer a strong basis for funds with a growth bias
Ethical investment provides outperformance in value-oriented funds
Joanne Roberts, director of online intermediary Needanadviser.com argues the case against ethical investing
Ethical funds due to their volatile nature may not always be a good investment choice, according to Roberts. She claims there is a huge degree of variance between the strategies of ethical funds, which can leave many investors out of their depth when choosing a fund to suit their needs in terms of income or growth and with an acceptable exposure to risk.
She says: "Ethical investors know they want to invest in an ethical or socially responsible way in line with their beliefs but, because of the variance applied to investment strategies, they could end up taking higher risk without the proportionate higher returns and without fully understanding the implications of their choices."
Roberts believes the scale of choice between strictly ethical, green and slightly socially responsible will greatly affect the returns to investors and the associated level of risk they are exposed to.
She says: "When the early ethical funds were originally launched the criteria for investment was strictly positive or negative. Companies were either included or excluded, depending on their business activities and their contribution to society. However, more recently, ethical funds have developed sophisticated investment strategies following demand.
"Governments have been placing environmental issues on their agendas, which has obviously increased the profile of this type of investment. Investment has also been dependent on sustaining the earth in general. What we are now starting to see from fund managers is the inclusion of green and socially responsible companies in investment portfolios, because of their positive contribution to society."
However, she warns, while this has benefited the investor with increased choice it has also muddied the waters in terms of whether funds are truely ethical or socially responsible. As the choice between ethical and socially responsible is vast, this can be confusing for advisers and investors, she adds.
The problem with ethical investment is many of the companies excluded are larger ones that have been and still are responsible for solid investment growth over a number of years, says Roberts, who believes they cannot be included because of their business activities, irrespective of their financial performance. In Roberts view, the fact these companies are excluded can have a serious impact on a portfolio in terms of narrowing its investment opportunities and therefore reducing diversification and increasing risk and the potential for volatile returns.
"Fund managers are having to exclude larger companies that have notoriously performed well but have a non-ethical business ethos and look at smaller and, therefore, more volatile companies in different areas," she says. "At some point returns may be higher because of their ability to take advantage of investment opportunities, but generally a smaller company's size and lack of funds could mean investors will miss out. This means volatility for investors and increasingly pushes the need for investments over the longer term."
According to Roberts, investors in the ethical arena must have a long-term view as with any other equity investor, in order to benefit from positive returns and need to regularly review strategy to ensure it continually meets their set objectives.
Investors must also be aware of the additional risks that come with investing in smaller companies, such as the financial viability of the firm they are investing in. Roberts says smaller companies tend to have more narrowly focused business activities and their profits are therefore more easily affected if their market falls.
Roberts stresses that ethical investors must be prepared for volatile returns because they are investing in specially selected and focused equities, which may not be as well diversified as other funds. This means the returns could be affected by non-systematic events, which affect the trading activities of the company, rather than more focused systematic events that affect particular markets, such as tobacco, oil and alcohol. In addition, she argues additional charges can be incurred by investors in ethical funds in return for having a specialist fund manager.
She concludes: "When this is added to volatile stock markets, as we are seeing at the moment it is vital for investors and their advisers to review their investment strategies on a regular basis to maximise returns and minimise risk."
Ethical funds demand more specialised fund manager input
Firms with ethical strategies tend to be more volatile in terms of returns
Larger companies tend to be excluded irrespective of performance
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