The Calculus of Conscience

Can investing and ideology profitably coexist? In financial circles, the answer has long been a resounding no. Letting moral or ethical guidelines limit investment choices, your stockbroker would assure you, could only have one effect — lower returns. But the strong performance in the past few years of many self-described ethical investment funds has prompted a rethink among financial analysts and has caught the eye of European investors eager to follow their moral and social convictions as they construct their portfolios.

In general, ethical investors steer clear of companies that traditionally have had some of the highest profit margins: the ones that produce tobacco, alcoholic beverages or weapons, as well as those with poor environmental or labor rights records. But contrary to expectations, the new, socially-conscious investment funds have performed as well or better than those focused purely on accumulating largesse. Over the last year, almost three-quarters of the ethical funds in the U.K. All Companies sector beat the sector's average fund performance, according to Standard & Poor's, a fund research agency. The U.S.-based Domini 400 Social Index, which measures 400 screened stocks, has beaten the S&P 500 — a broad-based index of U.S. equities — since 1997.

In spite of those brighter numbers, ethical funds remain a specialist sector, with far less money under management than mainstream funds. But that picture is changing fast. The number of investment products in the U.S. designated as ethical more than tripled from 1995 to 1999, and funds under management grew from $12 billion to $174 billion. Although Europe lags behind, demand is growing: in the U.K., the amount of money in socially-conscious funds increased from $1.2 billion in mid-1995 to $4.5 billion this year.

There are more than 40 ethical funds in the U.K., some 20 in Sweden, and a smattering across Belgium, France and Germany. Momentum is building, if slowly. Half a dozen new products were launched last year in Spain. For investors keen to go the private equity route, some venture capital houses also select their investments along ethically correct guidelines. In May, the U.K.'s Scottish Equitable launched Britain's first ethical corporate bond fund, for investors seeking income rather than growth.

Still, even given the good run this approach has had of late, this is not an area where investors should go it alone, particularly because they may find it hard to get information. "A lot of banks would be excluded because they lend to unethical companies," says Tom Collier, a funds analyst at Barclays Stockbrokers, by way of example, "but it's very difficult for an individual to find that out." And while it is true that some ethical funds have performed well in the past couple of years, it is also the case that many have had substantial exposure to "new economy" stocks — theoretically more socially responsible than smokestack industries — and tech stocks may not have such stellar performances in the future.

But if you decide you want to take an ethical approach in at least part of your portfolio, take a close look at how the fund you select chooses its investments. Funds tend to fall into two distinct camps. "Negative" ones screen out companies they deem socially irresponsible. "Engagement" funds will buy into almost any company with the intention of using shareholder activism to alter the corporation's behavior. "The engagement form [of ethical investing] doesn't necessarily affect stock selection at all," says Craig Mackenzie, Director of Socially Responsible Investment at U.K. financial house Friends, Ivory & Sime.

Such news could come as a shock to those investors who believe they have invested ethically, only to find they own stock in companies with poor human rights or environmental records. And critics of engagement funds argue that the funds they have under management are simply too small to force large corporations to change their behavior. Mackenzie disagrees. "Engagement is more constructive than screening," he says. "Avoiding investing in nasty companies does not make them change." In any case, funds earmarked for engagement look likely to increase — from July of this year, the U.K. government has required all British pension funds to declare their social, ethical and environmental policies. USS — Britain's third-largest private sector pension fund with about $30 billion under management — has already announced an engagement policy, Mackenzie says. In the future, he says, "We will have the clout to achieve things."

In the meantime, investors should remember one of the cardinal rules of investing — no more than 15% earmarked for specialist vehicles, with the rest spread over a mainstream mix of cash, stocks and bonds. Such diversification will allow for the pursuit of altruistic aims without causing unnecessary worry in turbulent markets.