Are ethical funds any good? The best ethical funds to invest in

I recently received a great question via Chatterbox which I answer in full in this article.  I've pasted the original question below for ease of reference:

Hi Damien,

I’m totally new to M2TM but really, really enjoying it so far. I thought I’d get involved and ask a question on the forum.

I’ve just read a piece on Good with Money about voting with your pound and putting your money where your morals are. And personally whilst I have noble intents in this area I do also want to balance it against the need to get a semi-decent return.

I don’t think there are any ethical funds which are in your Best of the Best. But I am wondering if you have ever done any research into which ethical ones are the best ones out there. I have a few ethical funds in my existing portfolio but want to make sure I am sticking the right ones in there that give decent returns, if any do.

The difficulties of investing ethically

To clarify for those of you who don't know, ethical funds aim to invest your money, typically in equities, in a way that is deemed morally upstanding. So to take a very simple example, an ethical fund manager wouldn't invest in the shares of tobacco companies. That's because it can be argued that tobacco companies make money by encouraging people to become addicted to smoking cigarettes which could ultimately kill them. If you invest directly into company shares yourself, and not via a fund, it's possible to make sure you don't invest in companies or industries that go against your morals. However it's still not an easy task. If you invest via funds it's certainly more difficult.

Here is an example of an investment mandate for a typical ethical fund investing in UK companies:

To provide income with the prospects of capital growth by investing in companies contributing to social well being and the protection and wise use of the natural environment. 

Now what that actually means in reality is quite broad. The mandate is determined by the fund manager and they have the discretion to pick and choose investments that fit their mandate without having to check with their investors. So you are buying into a very general ethical standard that won't match your ethics exactly. It also raises an interesting question, are fund managers the most moralistic people out there anyway, given the industry's previous discretions and tendency to profiteer? So if ethical funds don't invest in tobacco or weapons manufacturers what industries do they invest in?

I analysed the 15 ethical funds which reside in the UK all companies unit trust sector to see the typical industry mix. The first thing you will notice is that there is a skew towards investing in financial companies and technology companies. This is a trend that is in general true of nearly all ethical funds. The numbers in brackets represent the sector mix for a typical UK All Companies fund.

• Financials 23% (18%)
• Industrials 16% (15%)
• Services 13% (14%)
• Telecom, Media & Technology 11% (7%)
• Consumer Products 10% (12%)
• Health Care 8% (8%)
• Undisclosed 7% (2%)
• Utilities 5% (3%)
• Basic Materials 5% (7%)
• Others 2% (7%)
• Oil and Gas 0% (7%)

I then drilled down and looked at the top 10 holdings across these funds and the list looks like this:

1 PRUDENTIAL PLC
2 VODAFONE GROUP
3 GLAXOSMITHKLINE
4 ROYAL DUTCH SHELL
5 HSBC HOLDINGS PLC
6 ASTRAZENECA PLC
7 BT GROUP
8 WPP PLC
9 LLOYDS BANKING GROUP PLC
10 UNILEVER

Without going through the whole list one by one two companies jump out straight away. Royal Dutch Shell has been voted among the top 10 least ethical companies by various bodies in recent years. This is a result of accounting scandals, its poor environmental record including artic drilling and is operations in Africa to name just three. It also seems strange that HSBC is among the list of supposedly ethical companies according to ethical fund managers. Globally HSBC bank 'helped clients dodge millions in tax' and has been caught up in a money laundering scandal where it was accused of laundering Mexican drug money. Investing ethically is a minefield whether you invest via funds or directly. If you are the type of investor who invests in shares directly you need to satisfy yourself of every action that a company has or hasn't taken in the past (or plans to in the future) before deciding to invest. Of course that is based on the assumption that we are always in possession of all of the relevant facts about a company (which we are not). This also raises another interesting point. If a company was 'ethical' and had a fall from grace due to unethical behaviour it's likely that its share price will drop suddenly. Strictly speaking an ethical investor should, if they are true to their ethics, immediately sell out. The trouble is this can equate to buying high and selling low which is the complete opposite to what a successful investor needs to do.

I encourage people to invest their money how they wish to and if that is in line with a personal code of ethics then so be it. However the time, research and monitoring required makes ethical investing via shares unmanageable for most. So investing via an ethical fund is more accessible and realistic.

Do ethical funds produce inferior returns?

One immediate problem for investors wanting to invest in an ethical fund is that there is no sector of ethical funds. Many ethical funds have the word within their name but plenty of them don't. To solve this problem I screened all 2,000+ unit trusts to find all the ethical funds and there are exactly 73 of them. So ethical investors clearly have a very limited choice.

The sector with the greatest concentration of ethical funds is the UK All Companies sector with 15 out of a total of 241 funds. I wanted to test whether ethical funds underperform the typical non-ethical UK All Companies fund. To do this I created an index of ethical UK All Companies funds assuming you had invested equally across each ethical fund. I also created a non-ethical UK All Companies index in a similar way. The chart below shows the return achieved by a typical UK equity ethical investor and a non-ethical investor over the last five years (click to enlarge). The ethical route is in green while the non-ethical route is in red.

Over the stated time period there is nothing at all to separate the two approaches. Statistically the ethical route is marginally more volatile. That is in part because of its smaller number of constituents but also because of how the money is invested (which I come on to later). So over the last 5 years ethical investors would have fared as well as a typical non-ethical investor.

The more interesting question perhaps is does ethical investing actually give you the opportunity to outperform non-ethical investors or are you just destined for average returns? To answer this I took the returns for each of the 15 ethical UK equity funds for each of the last 10 years and compared them to the average across the UK All Companies sector. In the table below a blue square indicates that the fund outperformed the UK All Companies average for that calendar year. A red square indicates undperformance.  You can see that 2016 was a dismal year for ethical funds (which helps explain their exclusion from the 80-20 Investor fund shortlists). However they previously performed strongly from 2012 into 2015. Coincidentally this period also saw smaller companies shares more generally outperform their larger counterparts and highlights the trend for ethical equity funds to have a small and mid-cap bias. By contrast, 2016 was the year when companies with overseas earnings benefited from the fall in the value of sterling as a result of Brexit. Therefore the more domestically orientated smaller companies underperformed their larger counterparts. In addition sectors such as mining and oil (which ethical funds tend to avoid) performed well in 2016.

This apparent tendency to have a bias towards small and mid cap stocks (as well as technology stocks) helps explain the increased volatility ethical funds tend to demonstrate, as shown earlier. Yet style and sector biases don't just occur in ethical equity funds they are also apparent in ethical bond funds. In particular some ethical bond funds are over-exposed to the banking sector as illustrated in my previous piece The funds most exposed to a new banking crisis.

By investing ethically your ability to outperform will depend upon whether the macro environment has favoured the underlying style bias (which historically has always leaned towards mid and smaller sized companies as well as financial and tech firms). Interestingly since the US election the fortunes of smaller companies funds and larger cap funds have diverged as shown in the chart below (click to enlarge).

The outperformance of smaller companies was picked up by the 80-20 Investor algorithm at the end of 2016 and my £50,000 portfolio has had exposure to smaller UK companies since early January which has boosted its performance. In addition bank stocks have also performed well as the prospect of Trumpflation (inflation caused by Donald Trump's policies) has stoked expectations of an interest rate rise in the US. The potential move towards higher rates globally boosts bank profitability (because the products they sell you are rate dependent) and hence their share prices have tended to rise. If these trends continue then don't be surprised if an ethical fund or two returns to the 80-20 Investor shortlists soon

Ethical investing performance across sectors

If you click on the image below you will be taken to a full pdf which you can zoom in on. The chart shows the main ethical unit trust funds available to UK investors grouped by sectors. The chart shows the performance of each fund during each of the last 10 years. If their performance for that year places them in the top 25% of funds within the sector the square is coloured purple. If the performance puts them in the second quartile (i.e just above the sector average) the square is coloured green. Yellow indicates the performance is below the sector average and in the 3rd quartile of funds while red puts the fund in the bottom quartile (bottom 25%) based on performance.

This immediately gives you an at-a-glance way of determining those ethical funds that have consistently outperformed their sector peers (including non-ethical funds). As you can see there tends to be few consistently above average performers among ethical funds. Those that are are easy to spot as they have predominantly green and purple squares when you scan across the row.

Summary

Ethical investing can give you some semi-decent returns (to borrow the phrase used in the original question) but it is often a result of underlying trends that ethical fund managers' investment choices create. Ethical investors are mostly unaware of these, such as a smaller companies bias or the skew towards financial and technology firms. This limits the upside potential in an environment which doesn't favour these biases. Equally during periods which do favour the overweight positions ethical funds outperform, as they did in the UK All Companies sector between 2012 and 2015.

Of course ethical funds have a restricted choice of companies to invest in. For DIY investors this is compounded by the limited number of ethical funds to choose from in the first place. Even if we expand the universe and include ethical ETFs and investment trusts you only add another 40 possible fund choices, which is equivalent to a couple of funds per sector. So taking into account all of the unit trusts that takes the total ethical DIY options to around 120. That is dismal.

Setting aside performance, trying to invest ethically is incredibly difficult. How would anyone identify the best ethical funds (given that they aren't grouped together officially) without research like what has been provided in this article? Also the ethics of some of the funds are questionable. If you do want to invest as ethically as possible without giving up potential returns one approach would be to have an ethical core to your portfolio but invest more widely with a smaller part of it. Alternatively invest normally and take any excess profits you make and give them to a charity that touches you personally. It's not perfect but likely to be more profitable.