Looking beneath the bonnet and finding out exactly what investors have exposure to is more important in ethical funds than in any other area of the market, according to Jason Hollands, managing director at Bestinvest. 

Bestinvest is a proponent of ethical funds and includes a large number in its recommended buy-list; however, Hollands says investors must be especially selective in this area, as these funds vary so widely from each other. 

He identifies three areas investors need to be particularly wary of.


The definition of an ethical fund 

"Nothing is straightforward with ethical investment," says Hollands, which is exemplified by the inability of firms involved in the area to settle on a term for describing it.

Over the last 20 years, ethical investing has variously been reincarnated as socially responsible investment (SRI); environmental, social and governance (ESG) investing; social, environmental and ethical (SEE) investing; sustainable investing; and most recently responsible investing. 

Hollands says the situation is further exacerbated by the tendency to lump together very different types of funds under the same banner.

These include traditional ethical funds, which encompass a multitude of concerns and screen out “sin” sectors such as tobacco, alcohol, arms and gambling, as well as individual stocks that are evaluated as unacceptable. 

The umbrella term also includes funds that identify "best of breed" companies in terms of corporate responsibility across a range of industries, as well as environmentally friendly thematic funds and niche products focused on high-risk alternative energy stocks. 

"The commonly used classifications of ‘dark green’ and ‘light green’ are woefully inadequate in our view, since this masks the fact that there is no common approach to policy across various providers offering highly differentiated funds and processes," said Hollands. 

"Potential investors need to decide what the key issues of concern to them are – in particular whether they want a broad-based ethical approach or a more narrow focus on the environment – and then select a fund with a set of policies that appeals." 

"However, even then the likelihood is that you will still need to compromise on some of your convictions and understand that in some cases, the policies of the fund could change over time. Not all funds operate with a static definition of what is acceptable for their universe." 


The definition of an ethical company 

Hollands argues that most companies do not neatly fit into a definition of ethical or unethical but sit somewhere in between.

This means most portfolios will contain a wide range of stocks often chosen on the basis of a finely balanced evaluation either by the manager or in some cases an independent committee tasked with reviewing and developing policy. 

Therefore, he says, ethical funds are unlikely to please all investors all of the time. Many investors will be surprised to discover large banks, supermarkets and oil companies are held by ethical funds. 

"In particular, there are some areas of fierce and legitimate debate among ethically inclined investors both at the policy level and when it comes to individual stocks," said Hollands. 

He cites the highly controversial area of animal testing. Some ethical investors believe it is completely unacceptable while others regard it as a necessary activity for businesses involved in researching treatments for life-threatening diseases, such as HIV-AIDS and cancer. 

"At the stock level the inclusion of large supermarkets, fashion brands, banks and oil companies often arouse the most debate," he explained.

"Supermarkets can be pioneers in stocking ethically sourced goods and reducing their carbon footprint while also standing accused of aggressively squeezing suppliers." 

"Fashion retailers only have to have the tiniest exposure to the fur trade and this will incur the wrath of campaign groups."

"And while most ethical funds are light in their exposure to oil and other commodities, this is more down to the countries these companies operate in than oil being unacceptable per se – it is after all, a basic resource." 


Performance

"Perhaps more than any other sub-sector, it is not appropriate to assess ethical funds purely on past performance since you will not be comparing like-with-like," argued Hollands. 

"Performance on these funds tends to differ significantly from the mainstream indices at times, given their more restrictive universes."

"In particular, many of the 'sin' sectors – such as tobacco, alcohol and gambling – are quite defensive in nature, so ethical funds are potentially going to be disadvantaged during tougher markets." 

"However, it is important to recognise that some investors simply do not want their cash invested in these types of business and therefore it is vital that advisers are equipped with the expertise to help them choose an appropriate fund." 

Among the ethical funds with buy-ratings from Bestinvest are Aberdeen Ethical World, Jupiter Ecology, Kames Ethical Equity and Standard Life Ethical Corporate Bond.