• Consumers & Advisers
• National Ethical Investment Week
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• Course for Financial Advisers
• Introduction
• Step 1
• Step 2
• Step 3
• Step 4
• Step 5
• Appendices
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• Ethical Fact Finds
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Having completed your standard fact find, you should have a thorough understanding of your client's attitude to risk. For those clients who are interested in green and ethical investment, it is worth spending a little while on risk and performance issues relating specifically to such funds.

As with any other investment, advisers have a responsibility to make sure that their recommendations are suitable for the client and match the client's risk profile and other strictly financial objectives, as well as meeting their green and ethical investment aims. It is therefore very important that during the fact finding process the adviser should discuss the normal investment criteria of:

• Risk and reward – choice of asset classes
  
  
• Timescale
  
  
• Liquidity
  
  
• Income and capital growth
  
  
• Tax

There are now many investment funds, tax wrappers (OEICs, ISAs, CTFs, pension funds, onshore and offshore bonds), financial products and other types of investment from which to choose to meet the financial and green/ethical investment requirements of almost any investor.

Nevertheless, it is very important that clients understand the implications of their investment decisions. The adviser has the responsibility to explain to clients what impact the decision to invest in a particular fund (or other type of green and ethical investment) could have on the investment's financial performance.

Performance and risk issues are different for screened funds, which select stocks and make exclusions specifically on SEE grounds, and 'engagement-only' funds which generally do not. These are therefore covered separately below.

The conventional view is that screened green and ethical investment funds typically lead to substandard returns. The theory can be simply stated as follows:

• If a fund has a reduced investment universe, this will lead to underperformance.
  
  
• Excluding sectors increases tracking error from the benchmark index, and thus increases portfolio risk.
  
  
• Consequently, responsible investment is not mainstream and is only suitable for ethical investors who are prepared to accept some underperformance.
  

For example, where a fund does not invest in tobacco companies, and the tobacco sector is doing well, it is missing an investment opportunity and increasing risk. The fund will therefore underperform.

The well-established arguments against this view are described in section 4.2.

In Step 5, you will learn what to find out about specific screened funds so that you can assess how (and how well) the particular fund you are considering manages these aspects.

The case for screened funds that follow green and ethical investment criteria is as follows:

• Green and ethical investment funds vary greatly. It is inappropriate to generalise about them.
  
  
• The argument against green and ethical investment is confused with the argument against active management, as all active fund managers have to hold a manageable number of stocks in their fund.
  
  
• There may be long term financial advantages in some green and ethical investment strategies.
  
  
• There is considerable evidence against the underperformance view.

Green and ethical investment funds invest in a wide range of asset types and offer different screening and/or engagement approaches. Any attempt to treat them as a homogenous group is misguided. This is because their strategies are diverse, although there is some bias among them towards growth rather than value investment, and medium and smaller companies rather than the FTSE100 or the equivalent. Approaches are diverse because they attempt to meet the needs of different investors.

Some commentators mistakenly view green and ethical investment as a separate asset class. This view, while attractive for its simplicity, is also misleading, as there are many different approaches (both ethical and investment) adopted by different screened funds.

Both actively and passively managed green and ethical investment funds are available.

For actively managed green or ethical investment funds, success or failure is primarily a function of:

• Fund management skill
  
  
• Asset allocation
  
  
• Stock selection
  
  
• Risk control
  
  
• The accuracy of the analyst's views
  
  
• The overall quality of resources of the fund management house
  

In this respect, they are like any other active investment approach.

The view that restricting investment choice by removing the possibility of investing in certain companies leads to underperformance is really an argument against active fund management rather than green and ethical investment.

All active managers screen out stocks for various reasons. This is the nature of active fund management. Markets are generally efficient, but it is possible to derive additional performance from taking active market bets, which is why investors pay more for active management approaches than for passive management.

Screened green and ethical investment funds simply exclude or favour stocks based on long term environmental, social, ethical and corporate governance concerns – and thereby reduce the risks or maximise the benefits associated with these areas. This leaves a fund manager with a set of stocks from which he or she can select investments, and to which he or she can apply mainstream portfolio construction techniques – which is exactly what most screened fund managers do.

Screened funds are no different from other actively managed funds in using different sector weightings relative to mainstream benchmarks (extreme index-huggers excluded). The degree to which a particular green and ethical investment approach has a beneficial or a detrimental impact on performance will primarily rest with the skill of the fund manager and their team – and in particular their stock selection abilities.

There is a case for saying that green and ethical investment strategies can lead to long term outperformance and competitive advantage over conventional fund management approaches. For example:

• Fund managers focus on the longer term views of trends that conventional analysts have typically ignored in their company valuations, eg climate change, human rights and brand value. The advantage can be particularly marked where fund managers are supported by an experienced team that is able to identify possible valuation impacts of long term social, environmental and corporate governance concerns.
  
  
• A specialist focus on particular sectors or technologies could lead to outperformance, though possibly at the cost of higher risk.
  
  
• Corporate governance is often an important factor in corporate success or failure. When corporate collapses such as Parmalat, Enron, WorldCom and Ahold can have such a serious economic impact, any additional information about the governance of a firm, and its approach to and management of social environmental and ethical issues, could provide invaluable insight.

There is considerable evidence that funds that meet green and ethical investment criteria can perform at least as well as, and sometimes better than, other equivalent investment funds. The evidence is based on more than two decades of performance figures in the UK and other markets.

Recent assessment and evidence includes:

• A report from the Investment Management Association in July 2006 that said, “Investing ethically does not mean that you have to sacrifice investment performance. As with any investments, some perform better than others". (1)
  
  
• Several fund managers of green and ethical investment funds are rated as AAA or AA by Citywire, and a 2005 Lipper Citywire All Stars Award was won by an ethical investment fund manager. According to Citywire, “fewer than 5% of all UK fund managers achieve an AAA rating... If they do, it means that they have performed very well and are among an elite." (2)
  
  
• According to Money Management in March 2007, “the amount of negative and positive criteria has no definite effect on the performance of an SRI fund. But with a number of different kinds of SRI funds sitting at the top of the charts, there should be something to suit every kind of ethical investor." (3)
  
  
• A joint study on Corporate Environmental Governance by Innovest Group and the Environment Agency, published in November 2004, found that “better financial returns can be obtained from investing in companies which integrate environmental considerations into corporate governance and processes." (4)
  
  
• Investment Life & Pensions Moneyfacts wrote in August 2006: “It is possible to profit without sacrificing your principles… there are still plenty of examples where ethical funds have performed at least as well as, and sometimes better than, their conventional counterparts… Just like any other sector, it would appear that ethical and SRI funds have their own fair share of good and bad performers."

For advisers who favour the lower cost and possibly lower risk approach of passive investment, there are green and ethical investment index trackers.

A tracker approach can be used with screening or preference to track the universe of companies, and may reduce management costs while meeting other financial criteria.

A green and ethical investment index tracker fund may mean a narrower underlying list of stocks than conventional index trackers. However, some indices are relatively broad, eg FTSE4Good.

If used by a particular fund, some passive techniques could reduce the variation in performance between a responsible universe of stocks and a conventional index.

Although there are many arguments to refute the case against screened green and ethical investment funds, it is still important for an adviser to understand the characteristics of funds which may be recommended and to discuss the investment implications of certain strategies with the client. This is necessary both to select funds suitable for the client's financial objectives and to ensure that the client understands and accepts any differences from other funds.

Of course, you need to take account of what you already know about the client's risk profile so that you can tailor the discussion appropriately.

Typical characteristics that may need to be understood and, where relevant, explained are:

• Implications of the types of investment style adopted by some green and ethical investment funds, which may be more likely to be biased towards growth rather than value investing, or may be a thematic investment proposition based on emerging social and/or environmental changes or opportunities. Of course, if you expect to recommend screened equity income or bond funds, then this will alter what you need to discuss.
  
  
• The size of the companies held in different types of funds. Some funds may have a bias towards smaller companies in order to meet avoidance criteria, while others may focus more on larger companies by using a 'best of class' approach. Some thematic funds may have a small company bias inherent in their investment proposition.
  
  
• The techniques used by the fund to manage, and where necessary mitigate, any short term performance issues from the effect of differing sector weightings or other consequences of its screening criteria.
  

These characteristics can make a particular screened fund perform differently from common benchmarks in certain market conditions, although, as described above, not necessarily less successfully over the medium to longer term.

These aspects are very similar to those you will be used to considering for non-screened funds.

The issue of a restricted investment universe is less relevant for engagement-only funds, because engagement tends not to affect stock selection or alter portfolio allocation decisions. Engagement usually takes place with stocks that are already in the fund, rather than in advance of stock selection.

An engagement-only approach to green and ethical investment management can yield long term benefits to fund holders:

• Using engagement, shareholders aim to behave like responsible owners of companies, to look to the longer term and to encourage better business practices where it is believed to be to the benefit of all.
  
  
• Improved corporate responsibility, supported by investor engagement, may result in corporate benefits such as improved reputation, happier employees, and an ability to attract and retain quality staff.
  
  
• Engagement with a company can also help to inform fund manager opinions. Indeed, sell-side brokers at investment banks are increasingly researching social, environmental and ethical concerns to enable integration into their company analysis.
  
  
• Engagement may highlight potential future issues to companies to encourage them to build shareholder value over the long term.

Footnotes

1        See report from the Investment Management Association in July 2006

2        See Citywire

3        Survey: How ethical are ethical funds? in Money Management Green Investments Supplement, March 2007

4        See joint study on Corporate Environmental Governance by Innovest Group and the Environment Agency, November 2004

5        See the Investment Management Association's third annual survey of fund manager engagement with companies