Investors who have shunned ethical investment because they didn’t want to sacrifice their profits for their principles may have to think again.

After a barnstorming year in 2006, ethical funds have outperformed their nonethical rivals in the growth-orientated UK all-companies sector. There are 16 out of 20 ethical funds clustered in the top quarter of the one-year performance table and the Sustainable Leaders Trust, from the Cooperative Insurance Society, has become the first ethical fund to head the sector.

This achievement is all the more impressive because the ethical mandate of these funds does not allow them to select from certain sectors of the stock market. These funds, sometimes known, slightly confusingly, as “green” funds, screen out various companies on the basis of the activities they undertake. The darker the green, the more sectors are eliminated.

For example, the F&C Stewardship Growth fund, the oldest ethical fund, is a dark green fund. It does not allow its managers to invest in arms, tobacco, gambling, alcohol, most oil companies (for operating in countries with a poor human rights record), most pharmaceutical companies (because of animal testing) and some banks (because they lend to undesirable companies or regimes).

While some newer funds focus more on active engagement with companies, others, such as the recently launched Marks & Spencer Money Ethical fund and the 7IM Ethical fund, follow a similar pattern of exclusions to F&C’s.

The result is that an ethical fund manager, such as Ted Scott, of F&C Stewardship Growth, may have only about half the stocks in the FTSE all-share index to choose from. Like many other ethical funds, it is heavily weighted towards mid-cap stocks.

Jason Hollands, of F&C, says: “This has produced a double benefit in recent years.

The exclusion of oil stocks and pharmaceuticals has worked in our favour as these sectors have performed poorly, while our overweight position in mid-caps has also paid off because they have performed outstandingly well over the past few years.

“The restrictions placed on ethical funds mean that they have a smaller pool from which to fish, which forces fund managers to exercise their stockpicking skills. That they manage to beat a lot of the conventional funds that have no restrictions is both a tribute to their stockpicking skills and an indictment of many conventional funds that are not really actively managed but are simply closet trackers.”

Emma Howard Boyd, head of socially responsible investment at Jupiter, another manager of ethical funds, says that another reason for the recent outperformance is that ethical funds aim to be ahead of the game in identifying stocks that will benefit from new ethical or environmental trends, such as tougher rules on emissions.

She says: “We have more specialist knowledge than most other fund groups about things such as clean energy technology stocks. That is why we were one of the first fund groups to invest in Fuel-Teck, a US company that provides clean coal technology for power stations.”

Although the tide currently seems to be flowing strongly in favour of ethical funds, Justin Modray, of Bestinvest, the independent financial adviser, says: “The recent good performance may prove to be cyclical rather than permanent. It owes a lot to the good showing of mid-cap stocks. When this outperformance ends, ethical funds may fall back. Ethical funds may have outperformed their nonethical rivals over one, three and five years, but they trail them over seven and ten years.

“Many ethical fund managers do very well with a limited number of stocks, but they will struggle to beat the best nonethical managers consistently. Tiger Woods may be able to beat a good club golfer using only a driver, a putter and a five-iron, but when he competes against the best in the world, he makes sure he has a full set of clubs in his bag.”

Hand-pick investments for a clear conscience

Most individuals who wish to invest without compromising their principles put their cash into ethical funds. However, this is not the only ethical vehicle that is open to them.

Savers wanting to build up a nest egg can put their money into deposit accounts with the Cooperative Bank or Triodos Bank, safe in the knowledge that their savings will not be lent out to undesirable organisations.

If they want to assemble their own portfolio of shares they can call in the services of Eiris (ethical investment research services). Stephen Hine, head of international relations at Eiris, says: “Investors can come to us, either with an existing portfolio or starting from scratch. Working with their stockbroker, if they have one, we can screen an existing or suggested future portfolio for any particular stocks that don’t meet the individual’s ethical criteria. We can also report on stocks that pass the test on the positive side.”

Those investors prepared to accept a very high-risk option could put their money into the C-class shares of the ethically orientated Foresight 2 Venture Capital Trust (VCT), which invests in companies involved with recycling and renewable energy.

Justin Modray, of Bestinvest, the independent financial adviser, says that an increasingly popular option is for investors to buy shares in companies that might not pass an ethical screening test so that they can engage with them directly as shareholders.

CASE STUDY: Growing nicely

David Else, of Sheffield, has a twofold objective when he invests his money. Mr Else, who works for a publishing company, says: “I want to do the best for me, my wife, Corinne, and two children, but I don’t want this to be at the expense of other people or the environment.”

This is why the 46-year-old has, for several years, used some of his Isa allowance to invest in F&C’s Stewardship Growth fund. This is the UK’s longest-standing ethical fund, having been launched in 1984.

Mr Else, pictured with his daughter, Sarah, says: “The fund suits me because it screens out undesirable corporate activities. I do not want to invest in oil companies that pollute the areas where they are prospecting or throw local people off their land.

“In the same way, I do not want to put money into defence manufacturers that make guns and landmines. I appreciate the reasons behind the exclusion of gambling and alcohol (two other sectors avoided by the fund), but personally I am less worried about them, although I do agree with the ban on tobacco shares.”

Mr Else says that he is pleased by the performance of F&C Stewardship Growth, but adds: “I would have invested in it anyway, but it’s nice that it is paying off financially.”

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