Bank Rupture

You must wonder whether F&C Stewardship - the UK\'s first ethical fund - regrets a change in remit in late 2007 to relax its criteria on banks. When Friends Provident launched it as the first ethical fund in 1984, financial services practices included little consideration of the environmental and social impacts of the sector. This meant the fund avoided financial companies such as the major banks.

But the Committee of Reference, its filtering body which is independent of F&C and Friends Provident, reckoned that financial services companies had changed and so it agreed to revise its criteria: ‘in large part due to the growing influence of sustainable investment, a number of leading insurers and banks have come to integrate these factors into their core lending and insurance practices’.

And so the fund manager’s of the F&C Stewardship fund invested in RBS, Barclays and HBOS to name but a few. The rest, as they say, is history and the fund, which had begun to turn on its head the myth of ethical funds not being able to match their non-green counterparts, has plummeted to the wrong end of the performance tables.

A look at the ABI tables shows the fund has delivered fourth quartile performance against its non-ethical peers over the past one, three and five years. Indeed, during the five years to the beginning of February investors would hardly have made a bean.

Had the change in strategy not occurred performance could have been a great deal better. Instead, it may have harmed the green brigade foray into pensions given that it is frequently viewed as the flagship fund for ethical investing. Talk to employee benefits consultants, IFAs and pension consultants and ask them to suggest an ethical fund and the Stewardship name always gets a mention.

Jason Tse, certified financial planner at Barchester Green, the ethical IFA, says: “It is hard to explain to clients. It used to be one of our favourites for firms but the decision to include banks has hit performance.”

F&C is distancing itself from the decision: “The decision to allow selected financial stocks eligible – certain banks and insurers – was a policy change by the Committee of Reference which is independent of F&C and Friends Provident.

“Previously pretty much most of the big financials had been excluded on the basis that you don’t know who they are lending to, so they might be lending to businesses that would in their own right be excluded. The revised policy recognised that some banks had made strides in areas such as adopting the Equator Principles and ethical finance products,” says F&C spokesman Jason Hollands.

“Ironically, one of few parts of the banking sector that were originally eligible for investment were the mortgage banks, so from an investment point of view the widening on the universe meant the funds were less restricted to the likes of Northern Rock and Bradford & Bingley than they had been in the past for any financials exposure.”

It is perhaps not surprising that performance of many ethical funds has also come under the spotlight during the downturn. They had been turning the tables on their non-ethical counterparts until a year or so ago. But the past year has reversed the situation. As a general rule they have less opportunity to invest in defensive stocks such as oil and tobacco, while may typically invest in smaller and medium sized companies that tend to come off worst when investors run shy of shares.

Yet performance is always the burning question for ethical funds – seemingly more so than other funds. Survey after survey and report after report has quashed thought that performance is compromised. But ask providers whether they believe ethical investing comes at a price and you can almost hear the yawn – yet they admit that firms and trustees continue to ask the question every time the concept of ethical investment arises.

The Investment Management Association (IMA) is the latest to dispel the myth that performance is compromised when it presented to the Personal Accounts Delivery Authority last month at a seminar looking at socially responsible investing for the new national pension scheme.

“It is an extremely complex area as there are many variables and many different types of fund. It is difficult to conclude that SRI (ethical) funds outperform but you can rule out the notion that they underperform – they don’t,” says Jonathan Lipkin, head of research at the IMA. “You also have to remember that some ethical investors are less worried about benchmark related returns.”

Mercer, the consultant, says that a variety of factors such as manager skill, investment style and time period are integral to investment performance. It also agrees that the argument that integrating ethical, social and corporate governance factors into investment analysis and decision-making will only lead to underperformance simply cannot be made.

Emma Hunt, head of responsible investment, Europe at Mercer, says: “Fund performance is a question that is always raised when considering SRI fund choices. Mercer’s research suggests that you do not necessarily have to sacrifice performance when choosing an SRI fund. As with any fund, there will be outperformers and underperformers. Mercer does advise that with SRI funds, undertaking research into the fund is even more important, and choosing an active manager may be a preferable route.

Michelle Cracknell at Skandia, says: “Ethical investment does not have to be at the expense of investment performance and more and more people are choosing to invest ethically as many of us become increasingly aware of environmental issues.”

But despite reassurances over performance the growth of the ethical investment in the DC and GPP market is still subdued. The pensions industry says that there has been an increased emphasis on socially responsible investment but that it is still a slow burner when it comes to employees signing on the dotted line.

According to the National Association of Pension Funds, the number of options available to employees has stagnated over the past four years. The proportion of schemes offering an ethical option in 2005 was 40 per cent, whereas in 2006 it was 38 per cent, 40 per cent in 2007 and 39 per cent last year.

But even where there is an option, take-up has reportedly been slow. Skandia, for instance, has around 50 ethical funds on platforms. Yet, Skandia admits that ethical funds count for a very small percentage of its overall sales. Less than 1 per cent of its 2008 sales, less than 1 per cent of assets re-registered on to our platform and less than 1 per cent of funds under management are in ethical funds. (In the retail investor space, ethical funds account for just 1 per cent of the fund universe, says the IMA.)

Cracknell comments: “Increasingly, trustees are considering offering access to ethical funds but it would be dangerous for trustees to limit the choice to such funds. In fact, I advised trustees of a money purchase scheme where the sponsoring company was a conservation organisation and the membership were more likely to wish to select environmental funds. However, the advice to the trustees was that the investment range should not exclude other funds.”

Mercer says that a small but growing number of corporate DC schemes in the UK are considering an SRI option within their family of DC funds – particularly those schemes that are re-evaluating what they offer to employees. Some is demand led from employees and others the idea of trustees hoping to offer a suite of funds for all.

Hunt says: “We are seeing some demand from our DC clients, when they re-evaluate their schemes to include an SRI option. But it is a small and simmering issue. That said, five years ago it was not on the agenda at all. It is employee driven in some regard – it is line with the general trend. On offering a SRI Fund as part of the DC scheme, the uptake of the DC SRI option is still small, although they are a faithful group of investors. We do expect more schemes to offer a DC option over the coming years.”

One of the problems for ethical funds is choice. There are now more than 60 ethical funds available; a decade ago there were just a dozen. In the early 1980s, the handful of funds focused on the negative issues. The manager would not invest in stocks if they were associated with say, tobacco, brewing, armaments, oil or pornography. There are still such funds that take a hard-lined approach but the vast majority of funds focus on “socially responsible investment” or SRI as it is known.

Rather than screen out stocks, funds that follow the SRI route take a more positive approach, investing in companies that adopt good environmental and social practices, regardless of sector. This gives managers a wider choice of stocks, which can help boost returns and reduce volatility.

The quandary for firms wanting to offer ethical funds is which do they choose? But while most experts in the field welcome this choice, it does create additional problems. Firms must find one that not only meets their investment objectives but also matches their ethical convictions. Do they want a fund that adopts the SRI approach, or a fund that follows a stricter remit based on exclusion?

But despite this choice, platforms typically only offer a narrow range of funds. Consultants admit that the SRI fund options tend to be reasonably well-established funds appealing to a ‘broad church’ of investors, using both positive and negative screening criteria, with a layer of corporate engagement over the top of them.

Tse says: “The likes of Standard Life, Scottish Equitable and Scottish Widows only offer one type of fund.”

Cracknell echoes Tse’s sentiments. “We recognise that many people are taking a more proactive approach to environmental issues but, if they want to replicate this within their pension savings, they need to choose an open architecture product as access to a range of ethical funds that is wide enough to enable them to diversify away from just one or two funds,” she says.

Tse says there is another issue – the lack of demand is deterring providers from offering employees a choice. Providers are being more restrictive than in the past in offering funds to employers. Whereas previously just three members would have been enough to offer an ethical option, now there needs to be at least 10 or 15 members, says Tse.

“Profitability is key. Providers do not seem to like small numbers of members and potentially high turnovers. It is not cost effective – in the past it was possible to get bespoke solutions for clients – now that is more difficult,” he says. “If you are in a GPP and you want to invest in ethical funds, you will be very limited in the choice available with your provider, with possibly only a couple of fund choices,” says Tse.

It is a different scenario for group Sipps where there is a much wider range of ethical investment options available. “Some examples include Aberdeen Ethical World, Aegon Ethical and Henderson Global Care. In addition to purely “ethical” funds, there are others such as Jupiter Ecology where the screening of companies may be slightly different,” adds Lee Smythe, from Killik.

The cost implication could pour water on ethical funds ever becoming a staple part of the employee’s pension diet. According to the IMA SRI funds are not more expensive than ordinary funds – all funds tend to average a total expense ratio of around 1.6 per cent – but the problem for the pensions market is economies of scale.

Not only is this hindering take up now, it could pose a problem for Personal Accounts, which are committed to providing an ethical option. Questions will be raised on whether PADA will be able to deliver a cost effective ethical option come 2012 – the authority may have to consider a subsidy to be able to offer the choice.

Ethical investing in the workplace is destined to be a niche area for sometime to come – irrespective of the efforts of the SRI troops to make a difference.

Lipkin adds: “Around a quarter of people surveyed by the DWP reckon that they want to invest with a social conscience, but when the realities of saving for pension come to the fore they may be less willing to take an ethical stance.”

Ethical v non-ethical – 5 yr returns

Standard Life Ethical (balanced managed) 2.9%
Standard Life Managed 4.8%

Friends Provident Stewardship 0.4%
Friends Provident UK Equity 1.0%

Clerical Medical Ethical 1.2%
Clerical Medical UK Growth 0.0%

AXA Ethical -0.8%
AXA UK Equity 2.8%

Scottish Equitable Ethical 5.6%
Scottish Equitable UK Equity 2.2%

Source: Money Management Feb 2009