What constitutes a ‘good’ ethical strategy?

Despite more than £16 billion of UK retail funds sitting in ethical strategies, no universal definition exists for this set of funds

Tailoring a portfolio to drive positive social and environmental change is important to many investors.

Investment Association data shows that ethical funds saw net retail inflows of £91 million in October alone, taking total funds under management in this area to £16 billion by the end of month.

This total equates to a 1.3% share of industry funds under management, and yet there is no universal definition as to what constitutes an ethical strategy.

Lewis Grant, global equities senior portfolio manager at Hermes Investment Management, says: “When deciding whether to shift to an ethical investment portfolio, investors first need to go back to basics and set a clear definition of what they constitute as ‘ethical’.

“Exclusion or ‘negative screening’ perhaps offers investors the most direct approach to aligning their money with their morals.”

Grant explains that the definition of ethical parameters is only the start for many investors, who may also wish to consider the impact that ethical parameters may have had on historic returns.

“would their definition of ethical have detracted value? How would they have felt about it then?” he asks.

For Adrian Lowcock, spotting an ethical strategy that is going to make returns while doing good is no different from the challenge of identifying any strategy that is going to make good returns.

“You need to have a clear and consistent process and a fund manager with a good understanding of the ethical approach and why they are applying it. Given an ethical overlay will always narrow your investible universe, I think it is important to have managers with above average skills in risk management and portfolio constructive so they can minimise as much volatility as possible,” he explains.

“Diversification is key as ethical is likely to result in increased volatility at least in periods and investors need diversification to protect against this in the short term.”


Devil in the detail

The ethical landscape has evolved in recent years and for investors and their advisers, it is no longer simply a case of excluding certain sectors and including others.

Steve Bates, CIO at GuardCap Asset Management, explains: “Obviously, it is easier to meet guidelines where you are investing in some sectors rather than others (e.g. consumer stocks vs. energy and resources), but even where you are in areas (either geographic or sectoral) where companies struggle to meet ethical guidelines, there are good companies and bad.

“Also, recognise that there isn’t a perfect answer. If you don’t like fossil fuels, what do you do about utilities generating power from nuclear? What about the infant nutrition market where substitutes allow women back into the workforce? The problem with box ticking is that you will miss all the subtlety, which is why analysis should focus instead on the investment process, which in some cases may not even be highlighted as ethical, but is by its nature as the manager believes that this is where the best returns will be found.”

Lowcock adds: “[The strategies] have switched from being more about avoiding companies which do bad to looking for good stories companies which have a strong ethical policy and philosophy.

“More businesses are understanding that a good ESG policy is actually good for the business so it’s not just a case of avoiding bad companies in unethical sectors but can be about supporting change and good practice in those sectors.”

One example highlighted by Grant is a coal company that, for an investor, could be on an exclusion list based on their current business model. However that same business may be increasing its focus on renewables and potentially be a future green leader.


Avoiding the spin

For fund selectors faced with the challenge of identifying the wheat from the chaff when it comes to ethical strategies, it is important to focus on the resource that has gone into the product and the level of expertise the management company has in the area.

Lowcock explains: “[Spotting an ethical strategy that isn’t simply marketing spin] is always hard as some ideas might not be successful for other reasons. ESG funds are growing in popularity and the successful fund managers have it at the core of their investment process i.e. not just in ESG funds. Others are specialists in niche areas, so see if the fund matches their skill set.”

Steve Bates, CIO, GuardCap Asset Management, adds: “You should look for a strategy where the issues surrounding ethics, which includes diversity and other aspects of sound governance are actually baked into the investment process and where it is not just a box ticking exercise. You should look at statements of these principles on a manager’s website and then follow it up by looking at which stocks are held to ensure that the basic principles are being enacted.”