Auto-enrolment will make capitalists of millions of Britons whether they like it or not. So just how much attention will providers and advisers have to pay to ethical investing
asks Emma Wall
Once the sole concern of Birkenstock wearing hippies, the concept of ethical investing has entered the mainstream. Just as for many supermarket shoppers the default option is now to plump for free-range eggs and meat, investors increasingly understand the need to scan companies’ ethical credentials before they deposit cash.
High profile disasters such as the recent collapse of a clothing factory in Bangladesh make investors think twice before investing in retail – and sin stocks such as arms dealers, cigarette makers and gambling companies have long been off the menu for the socially responsible, regardless of the potential yield.
There is even a series of indices – the FTSE4GOOD series launched in 2001 – that lists ethical companies for investors to peruse.
Against such a backdrop the advent of auto enrolment should be putting schemes under pressure to accommodate these ethical investors. But according to Ryan Taylor, senior DC investment consultant at Aon Hewitt, ethical investing is not on the radar of either portfolio advisers or members.
“The perception is that most auto-enrolled individuals are even less engaged than the average investor – otherwise they would be in the pension plan in the first place. Therefore they are not particularly focused on where their money is invested,” says Taylor. “There is also the challenge that most ethical funds are not priced at alternative default fund levels, which makes it extremely difficult to implement.
“Governance groups are starting to ask more questions of all fund managers though, although this has been driven more by the recent financial activities rather than specific ethical issues.”
That is not to say there is no appetite at all – Aon Hewitt recently introduced an ethical lifestyle fund for a client. Taylor said that some clients want an option in their core fund range – whereas others are still happy just to ensure there is an option somewhere in the fund range.
AllianceBernstein has taken a much more proactive approach –launching a new range of ethical target date funds last month to the UK defined contribution market aimed primarily at the third sector.
AllianceBernstein managing director, client relations Tim Banks says the extra six to seven million employees coming into DC pension schemes through auto-enrolment will inevitably increase the number of savers who want their ethical beliefs reflected in their pension savings. “We need to ensure that DC savers who have an ethical belief have this taken into account in an investment strategy that meets the retirement needs of a modern workplace environment,” he says.
EIRIS is a not for profit organisation that provides research into corporate environmental, social and governance performance.
The company advises many large pension funds – which it says have become increasingly interested in how long-term value is affected by environmental, social and governance (ESG) factors. Legal requirements as well as member and sponsor interest are driving this agenda.
It credits climate change and the global recession for causing pension schemes to sit up and take notice of ethical investing.
“Climate change, which may destroy up to 20 per cent of GDP, and the widespread losses caused by the credit crunch have highlighted to many pension funds how failures in foresight or governance and social or environmental problems can damage value, both long and short term,” it says.
EIRIS follows the investment principles of ESG – environment, social and corporate governance, and according to a white paper produced by Deutsche Asset & Wealth Management for the Global Financial Institute, responsible investment offers opportunities to generate higher returns with lower levels of investment risk.
The paper, written by Andreas
Hoepner, deputy director of the Institute for Responsible Banking and Finance, highlights the fact that the “total volume of responsible investments has increased almost ten-fold over the past 10 years. In his view, the key driver of this has been the demand from investors to focus more closely on ESG criteria”.
Researchers at the Universities of Maastricht and Reading have demonstrated that companies which enjoy a higher ESG rating, have higher credit ratings and lower cost of capital on average. Hoepner concludes that a lower downside risk is found in responsibly oriented portfolios, even if they are less diversified.
The problem arises when DC scheme members – as with all investors – have to choose between an ethical stance and performance.
Prior to the credit crisis, flows into ethical funds were high. When the rest of their portfolios are soaring, investors feel they can afford to include a moral element in some of their holdings.
Fast forward to 2013, and although the FTSE 100 is back on the rise, it has been a bumpy few years getting here and it has been the Steady Eddie blue chips – such as British American Tobacco – that have best survived the ride.
“Some employees are interested in ethical – the majority are interested in returns,” says Taylor.
It’s a difficult battle to stage – ethics versus returns. The MSCI World Tobacco Index had the highest return out of 67 groupings in the MSCI World Index in the 10 years to 2011 and last year was British American Tobacco’s most profitable year on record in the UK.
Members may also be put off from choosing an ethical default if it meant any reduction in choice and diversity.
Banks says: “As ethical awareness increases in society more and more employers want their pension investment reflecting this belief. But it is important that an ethical pensions strategy is equal in quality, flexibility and age appropriateness to the modern default schemes. Employees must trust that their ethical belief will not compromise them getting a robust and flexible investment strategy.”
It is estimated that up to nine out of 10 auto-enrolment members will opt for a default scheme, so it is important for companies to ensure their default scheme is the best possible option – regardless of ethics.
Banks argues that contrary to popular opinion it is possible to offer ethical choices, performance and diversity to scheme members.
“A company opting for our range of ethical target date funds will benefit from the same flexible investment strategy and dynamic asset allocation as our other default schemes. Our strategies are designed to reflect our clients’ investment belief,” he says.
Banks says the initial focus of companies has been to ensure the auto-enrolment process goes smoothly. “As the next step they will be reviewing their investment options and as a result we expect to see more discussions about ethical target date funds in the months ahead,” he says.
While Now: Pensions only has one fund that it offers to scheme members, CEO Morten Nilsson, is keen to stress that ethical principles are at the forefront of they way the company operates.
“The practice of ensuring responsibility in investments has been an integral part of ATP’s asset management – our parent company – for many years and ATP has always invested in line with the UN Principles for Responsible Investing,” he says.
“For us, social responsibility and ethical investment are about more than just box ticking in order to serve a perceived customer demand.”
How green is green?
Ethical investing covers a broad remit – meaning not all ethical funds are the same. In the past, ethical funds took a hard line approach to what they invested in sticking to extremely stringent rules as to what passed as “ethical”, but the sector has evolved in line with its updated moniker “socially responsible investment” (SRI).
Rather than screen out stocks, funds that follow the SRI route take a more inclusive stance, investing in companies that adopt good environmental and social practices regardless of sector. This gives portfolio managers a wider choice of companies to choose from, which can help boost returns and reduce volatility. It is also why stocks such as BP made the grade for some ethical funds – even after the 2010 Gulf of Mexico disaster.
Audrey Ryan, manager of Kames’ Ethical Equity fund, describes ethical funds as ranging from ‘dark green’ to ‘light green’. Dark green funds have the most restrictions on them, with her fund widely considered among the darkest green. Its 40.4 per cent return over five years is 7 per cent ahead of the UK All Companies index
Other dark green funds would include the oldest and biggest ethical fund, F&C Stewardship, which has always had a strict ethical investment policy – it screens out stocks that it considers unethical, such as tobacco, oil and armament firms. It originally shunned many financial and mining companies, because it deemed their practices to include little consideration of environmental and social impacts, although this has now been relaxed.
Light green funds are SRI funds that invest in companies that behave more ethically than their peers.
For example, should the manager want exposure to a mining company it would plump for one that inflicts the least level of damage on the environment and prioritises human rights and corporate governance.
Sharia investing and auto-enrolment
There is a large overlap between ethical banking principals and those associated with Sharia finance. The ‘darkest green’ ethical do not invest in any sin stocks nor any company who does not prioritise its responsibility to society and the globe.
The Islamic Bank of Britain – the country’s only wholly Sharia compliant retail bank – is based on a “more equitable system of finance than conventional interest-based banking”.
The Bank says that each product is designed around specific Islamic finance principles that “are derived from trade, entrepreneurship and risk-sharing in which the customer and Islamic bank work together as partners towards a mutually profitable end”.
According to the bank, the whole premise of Islamic finance is to provide a way for society to conduct its finances in a fair, ethical and socially responsible manner.
As the paying of interest on a loan is not Sharia compliant, the bank’s mortgage product uses the Islamic finance principles of co-ownership – known as Musharaka – with leasing – called Ijara – so the bank and the customer buy the property as partners and the customer pays rent on the bank’s share in the property.
While there is a large appetite for Sharia compliant retail banking, there have been fewer gains made in the pensions market.
“Sharia compliant investing is often regarded as an even lower priority option than ethical,” says Ryan Taylor, senior DC Investment Consultant at Aon Hewitt. “Even in companies where the expectation is that the Sharia fund would be the only investment option selected by members, a large number of members are happy to invest in alternative funds.”
AllianceBernstein’s Tim Banks says that if required, flexible target date funds can accommodate a vast variety of investment approaches as their default option, and that includes a Sharia strategy.
Now: Pensions CEO Morten Nilsson says that so far, he has seen very little demand from either employers or employees for a Sharia compliant fund. But he says the provider will partner with a Sharia partner soon.
He concludes: “We do not want any members to lose out on the benefits of auto enrolment due to not being able to invest in a Sharia compliant fund therefore external due diligence has been conducted on behalf of the trustees to appoint a provider to meet this need. We hope to be able to announce the partnership shortly.”