How ethical are ethical funds?
Conservative party leader David Cameron's recent struggle to erect a wind turbine on his roof in central London is symbolic of the green frenzy that has gripped the UK over the last couple of years as politicians, celebrities and companies seek to out-green each other
Even the normally staid world of investment has not escaped this phenomenon. In a world were ethical and especially environmental issues have achieved an unprecedented level of awareness, it is unsurprising that an increasingly large number of investors are choosing to define their investment criteria in social, environmental and ethical (SEE) terms as well as the more conventional metrics of risk, reward and income.
As befits an emerging sector, Socially Responsible Investing (SRI) has evolved rapidly over the last two decades. While older funds tend to have the strictest criteria, imposing severe limitations on the investment opportunities available to the fund manager, newer funds tend to adopt a best of sector approach.
This more pragmatic style lends itself well to a more positive outlook, with analysts seeking to identify the least harmful or most beneficial constituent in each sector, rather than the more traditional approach of excluding entire industries. Newer funds therefore tend to have a significantly broader pool of investment opportunities and therefore produce returns nearer to that of the benchmark index.
Consequentially the stock lists of this new breed of SRI funds appear very similar to conventional funds and include companies which would have been considered entirely unacceptable 20 years ago (and may still surprise investors new to SRI).
All that glitters
Lonmin is a perfect example of this trend. Two decades ago, ethical investors would have recoiled at the inclusion of a South African platinum producer, encompassing the twin bogies of Apartheid South Africa and mineral extraction. Yet now, the perceived SEE benefits of its operations more than outweigh its negative impact.
Clearly South Africa is no longer the shunned nation of the past. However, for many traditional green investors, mineral extraction remains a core area of exclusion. Yet, platinum is a key component of hydrogen fuel cells, a zero emission energy source that many hope will significantly reduce carbon dioxide emissions in the future. This platinum must be mined and South Africa has some of the world's richest deposits.
Additionally, Lonmin prominently displays both a Social Responsibility report and social charter on its website. This willingness to place SEE issues at the forefront of its corporate communications is indicative of a desire by company management to reach a previously untapped investor base.
Banking on a change
Another example is Standard Chartered, the London-based bank with extensive operations in Asia and the emerging markets. Many commercial banks were avoided in the early years of the SRI movement due to their involvement in the debt crises that wreaked havoc in the developing world. With the crises now abating, banks have been brought back into the fold as viable destinations for investor's capital.
However, the inclusion of Standard Chartered in a portfolio may still surprise those with an interest in human rights. As you would expect of an emerging markets specialist, Standard Chartered has operations in some of the more challenging corners of the world, including China and Indonesia. Despite operating in these regimes, some ethical managers are happy to include Standard Chartered in portfolios because of its positive influence in the continued development of these troubled countries and its perceived status as the best way to gain exposure to emerging market banking.
So, where next for SRI? As previously excluded sectors, become core holdings, what are the likely candidates for inclusion in the funds of tomorrow?
The most obvious next step is nuclear power. A key exclusion of even the most progressive SRI funds, its use is rapidly gaining acceptance by environmentalists as concerns about carbon emissions and climate change outweigh those over the environmental impact of radioactive waste.
On the social agenda, involvement with oppressive regimes is also losing its status as a defining criteria of the SRI sector. Emerging market exposure is rapidly becoming a core holding for risk hungry western investors seeking high reward opportunities. This trend is characteristic of a greater focus on environmental concerns at the expense of social issues.
This change in the character of the sector reflects both the religious origins of the SRI movement and the increasing awareness of environmental issues centred on concerns about climate change. There appears little likelihood that this trend will abate and we can expect continued dominance by green issues for the foreseeable future.
Although the SRI has become less strict over the past decade, the oldest (and strictest) funds have retained their position as the giants of the industry. While age, public awareness and performance track record all have an impact of the size of a fund, it could be argued that easing the SEE criteria has not only failed to attract new investors in the numbers originally envisaged, but also alienated hard-core SRI adherents.
As a result it is conceivable that the long-term trend may return to a more strict approach, as investors and consumers increasingly demand higher environmental standards. However, unlike in the past when strict SRI criteria equalled a paucity of investment choice, the future may be characterised by a broadening of opportunities as companies embrace corporate responsibility. While a proportion of this fashion to green wash companies is undoubtedly more spin than substance, in general this wholesale change should reduce benchmark risk and demolish the final barrier to SRI gaining wide acceptance amongst institutional investors which is good news for the planet as well as investors.
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