Does Ethical Investment Pay? EIRIS research and other studies of ethical investment and financial performance

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Does Ethical Investment Pay?

EIRIS research and other studies of ethical

investment and financial performance

Ros Havemann & Peter Webster

September 1999

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Copyright EIRIS 1999. All rights reserved. No paragraph or other part

of this publication may be reproduced or transmitted in any form or

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written permission of EIRIS.

Whilst all reasonable care is taken to ensure the accuracy of any

information provided, no liability shall attach to EIRIS in respect of

any contents of, or omissions from, this publication reproduced in

any way.

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About EIRIS

The Ethical Investment Research Service (EIRIS) was set up in 1983 with the help of

churches and charities which had investments and needed a research organisation to help them put their principles into practice.

EIRIS

•

provides the independent research into corporate behaviour needed by ethical investors

helps charities and other investors identify the approach appropriate to their requirements

publishes guides to help investors and advisers identify and choose between funds with ethical criteria

enables each investor to create a portfolio that reflects their own ethical concerns offers services for all types of client, from checking a portfolio to creating and implementing an ethical investment policy

concentrates purely on ethical research and does not offer financial advice or investment management services

About this report

Please note that EIRIS is not involved in the business of giving investment advice, nor is it an authorised body under the Financial Services Act. Our intention in this report is to present information on the general question of the impact of ethical criteria on financial return. However we must stress that nothing within this report should be taken as a substitute for appropriate financial advice which should always be obtained before making investment decisions. This report is intended for fund managers, financial advisers and investment consultants within the ethical investment industry, and for academics interested in this subject.

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There are a wide range of ways in which ethical or unethical behaviour could influence a company's commercial success and its share price, and the use of ethical criteria in the selection of a portfolio of shares could also have a variety of positive or negative effects upon investment performance. This report develops a model of the range of factors that could be relevant, and whose links with financial performance need to be increasingly understood by company managers, analysts, fund managers and investors in general.

In theory any investment strategy other than holding a portfolio looking exactly like the market in general involves a less than optimal balance of risk and return. A number of studies have attempted to measure the theoretical loss that arises from such a "sub-optimal" strategy. They all arrived at very small figures (less than 0.1% return a year, sometimes significantly less) even when considering quite draconian restrictions (typically ruling out half the market or more).

A range of "event studies" now show that in practice ethical news of one sort or another can influence a company's share price for good or ill. Effects between 0.5% and 3% of share price have been identified in a variety of studies. Such effects are

obviously significant for the managers of the company concerned, although it should

be noted that from the perspective of portfolio managers such individual stock price

movements would not move many portfolios significantly up or down the performance ranking tables on their own.

Studies of the effects of the performance of investment universes constructed on an ethical basis also tend to show overall performance very similar to the market indices, although tracking errors of 2-4% are also common in the studies available. This report details an EIRIS study of five different approaches to ethical investment, all of which result in risks and returns broadly similar to the market over an 8 and a half year period, despite being quite various in terms of the stocks affected, the proportion of the market avoided, and the balance of sectors that results from the policy adopted. The exercise also illustrates the diversity of approaches that might fall within the general heading of "ethical investment".

In the UK ethical unit trusts have been in existence since 1984 when the Friends Provident Stewardship Fund was launched, although the majority of available ethical

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unit and investment trusts have been launched post 1990. A number of ethical funds now have a track record long enough to assess their performance, though as they have very different ethical policies and approaches it is difficult to draw general conclusions from them as a group.

Studies of "real life" ethical investors (normally studies of the performance of ethical investment funds) have generally not identified a consistent "cost" to ethical investment, and some have identified out-performance for various approaches over different time periods. This study reports on EIRIS research into the longer-term performance of 15 UK unit trusts, and finds surprisingly that they appear to have lower total risk than other funds with the same financial objectives and geographical focus. Although on average they also have somewhat lower returns, the position is quite diverse, and a number of the funds have done relatively well over significant periods of time. The study would appear to support the contention that you can get good financial performance within an ethical framework.

It also raises further questions about how some approaches over some periods have been more successful than others. It does not appear that the answer lies entirely with the ethical approach itself but rather in how the fund manager attempts to deal with the challenge of investing within an ethical framework. As more investors seek an ethical approach, further research is needed to understand how different fund management approaches interrelate with different ethical frameworks to produce good (or not so good) financial performance for the investor.

Whatever the financial impact (positive or negative) which may be involved by applying a particular ethical policy, it would be possible to reduce those effects by weakening the ethical criteria used or applying them in different ways. For example, by allowing companies into the portfolio which derive only small amounts of turnover from an activity of concern, or by achieving a market sector weighting for the portfolio by applying a best of sector approach.

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1 Background

The use of ethical criteria in investment decision-making has grown in popularity since the mid-1970s. In the UK there are now more than 40 unit and investment trusts with ethical criteria, valued at over £2 billion. The chart below illustrates the growth in the market.

Figure 1: Growth of ethical unit and investment trusts 1989 - 1999

0 500 1000 1500 2000 2500 £m 1989 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year (quarter 2)

The chart above does not include ethically screened investments of charities, pension

funds or individuals investing directly. Just over £14bn1_{of charity funds probably have}

some degree of ethical constraint, however small (£8bn of which is the Wellcome Trust’s portfolio with tobacco only exclusions).

There would also appear to be a large amount of demand for ethical investment

products, which is as yet unmet. According to an EIRIS/NOP survey2_{more than}

three-quarters of adults think their pension scheme should operate an ethical policy. Of the 493 adults surveyed, 77% agreed their pension scheme should operate an ethical policy whenever it can do so without reducing financial return. Of these, 39% said their pension should operate an ethical policy even when it may reduce the size of their final pension. The survey demonstrates a need for more understanding of the impact of ethical criteria on the financial performance of investments.

1 NGO Finance research, August 1997

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One of the most commonly asked questions on ethical investment is whether there is a trade-off in terms of financial risk and return. However the answer is not straightforward. The ethical criteria of different ethical investors vary enormously since each investor has their own idea of what is ethical and their own approach to investing ethically. Different approaches employed include avoiding investment in companies whose activities you do not agree with, seeking to invest in companies demonstrating best practice within a sector, balancing a range of positive and negative company attributes to select the best ethical performers, or combinations of these three. Ethical investment may in practice mean anything from excluding a few tobacco producers to using a wide range of criteria on a large number of issues. The impacts of these various ethical policies ranges from excluding only a few percent of the FTSE All-Share Index by market capitalisation to excluding three-quarters of the market. To assume that diverse ethical policies will have the same effect on portfolio performance is clearly not sensible. The answer to the question ‘Does ethical investment pay?’ will depend on the ethical criteria and approach used, as well as the performance of the fund manager (for actively managed funds), the period over which performance is measured and a number of other factors.

Many ethical investors also engage with companies, trying to influence them on issues of concern. Where companies can anticipate financial reward for changing policy, ethical investors are most likely to be successful in influencing companies. So exploring the link between ethical investment and financial return may also be important for those engaging with companies.

It should be recognised that in any case the issue of financial return for some ethical investors is not of primary importance. Some individuals may be willing to accept a lower return in order that their investments do not compromise their beliefs, in the same way that some consumers will pay a price premium for fair trade goods. According to the EIRIS/NOP survey in June 1999, 39% of pension fund investors agreed their pension should operate an ethical policy even when it may reduce the size of their final pension. There is also some evidence to suggest that ethical investors are more loyal than the average investor in a conventional fund. According

to a 1997 computer simulation study3_{“ethical investors generally stayed ‘loyal’ to}

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In the case of pension funds the issue is of paramount importance and a major barrier to ethical investment, since trustees have a fiduciary duty to invest in the best (financial) interests of the beneficiaries. For those that have particular concerns about financial return, greater understanding of the relationship between ethical investment and financial return may encourage them to adopt an ethical investment policy.

In this report we explore the question ‘Does ethical investment pay?’ by examining the results of research into financial performance. Chapter 2 looks at the possible ways in which ethical investment criteria can impact on financial performance. Chapters 3 and 4 include an in-depth look at the research recently undertaken by EIRIS. Chapter 3 covers the research into the performance of five ethical indices constructed using different sets of ethical criteria and Chapter 4 looks at the historic long-term performance of ethical unit trusts in the UK. Research into theoretical ethical indices shows how much the restricted universe is responsible for differences in financial return and risk. The research into the actual performance of ethical unit trusts takes into account any charges as well as the fund manager effect. Chapter 5 summarises academic research undertaken by others in the USA and the UK on actual ethical portfolio performance, theoretical ethical portfolio performance and ethical behaviour links to company performance.

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2 Modelling the performance effects of ethical

criteria

2.1 Introduction

There are a number of different ways in which ethics could influence performance. Firstly, it can impact at the company level and secondly at the ethical portfolio level. Before reporting on the results of the research in chapters 3 to 5, we attempt to explain these different influences and understand how risk and return can be affected.

2.2 Company

effects

Figure 2: The effects of ethical behaviour on company share price

Employees

- motivation Government legislation COMPANY- strategy Customers Shareholders

Company sales - price - volume - market share Cost of capital SHARE PRICE Cash flow Company costs - productivity - costs - supplier relations EIRIS 1999 How can perceived ethical or unethical behaviour influence share price? According to

Milton Friedman “the social responsibility of business is to maximise profits”. Others4

argue that this belief does not describe what the most successful companies actually

do. The Centre for Tomorrow’s Company5 _{examined research into stakeholder}

relationships and company success and in conclusion states that “considerable

4_{John Kay,}_{Good Business}_{, March 1998}

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evidence is beginning to accumulate of the links between the inclusive approach and sustainable business success”.

In this section we examine the ways in which company strategies or policies perceived as ethical can impact on share price. Figure 2 shows a model of the effects of ethical behaviour from the company perspective. This model shows the main links between the company, shareholders, employees, customers and government and how ethics can impact on a company’s cash flow in terms of costs, sales, and the cost of capital.

The World Business Council for Sustainable Development6_{stated “we are convinced}

that investment managers stand a good chance of improving their portfolio performance and reducing their risks if they pay closer attention to the environmental performance of the companies in which they plan to invest”. It found that there were ‘downside’ factors which may serve to depress investment returns and ‘upside’ factors which could benefit companies. The downside factors outlined were: the cost and availability of capital; increased liability claims; expanded rules on disclosure; greater emphasis on environmental factors in credit-risk ratings; the availability and cost of insurance; the emergence of environmental taxes; and the increasing use of economic arguments by ecological pressure groups. The upside factors included: increased consumer demand due to increased ecological concern; increases in resource productivity; market share growth and new business development due to companies recognising the potential offered by the upside factors.

Reputation

Perceived ethical or unethical behaviour can have an impact on reputation and share price. The recent history of Shell highlights how a company can be sidetracked by wider social issues. The 1995 Shell boycott resulting from the company’s attempt to dump its Brent Spar oil platform in the North Sea showed a willingness by the consumer to favour companies whose policy it is to respect the environment. Some months later Shell found itself at the centre of international controversy for its operations in Nigeria in relation to that country’s poor human rights record. Pressure from consumers and shareholders concerning these aspects of the company’s business forced it to recognise that “the separation of business from wider society is

6_{The World Business Council for Sustainable Development}_{, Environmental Performance and Shareholder Value}_,

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no longer possible”7_{. The growth in social auditing and the development of programs} such as PriceWaterhouseCooper’s Reputation Assurance reflects increasing corporate recognition of this.

A study by Klassen and McLaughlin in 1996 found that the marketplace rewarded companies that developed strong environmental management programs (see section 5.4.4). In contrast they found that environmental disasters such as oil spills reduced company share prices in excess of the direct clean up costs.

Legislation

Government legislation has a role to play. Fund managers of environmental funds also claim that the companies they select for investment because of their proactive stance on the environment, be that using the latest environmental technology, minimising damage to the environment or operating ‘best practice’, will benefit from future legislation and regulation by being ahead of the game. For other firms environmental legislation can be a burden.

Company policies

Improved environmental performance can lead to cost savings by preventing environmental liabilities, and reducing materials and energy consumption. At the same time it should be recognised that some behaviour ethical investors favour is very unlikely to be more profitable for a company, at least in the short term. For example a decision by a company to turn down a lucrative military contract with an oppressive regime is not likely to increase profits unless the company can find an equally profitable contract elsewhere or the long term effects on reputation prove more beneficial. Similarly not all efforts to reduce impact on the environment may save money or earn a reward in the marketplace.

Consumers

Companies are increasingly recognising that they have to pay attention to all their stakeholders. Consumers concerned about unethical behaviour can of course harm sales - a recent MORI poll found that 3 people in 10 had chosen or boycotted a product or company for ethical reasons in the last 12 months. Campaigning organisations are increasingly targeting their campaigns against large multinationals,

7_{Mark Moody-Stuart, chairman of Shell Transport & Trading,}_{Financial Times Guide to Responsible Business}_,

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and using the power of consumers and investors whose awareness of ethical issues is growing to persuade companies to change.

MORI has developed a model for assessing the key relationships of a business,

called the Relationship Hierarchy8_{. This proposes that the key relationships of a}

business can be thought of in terms of a hierarchy, as shown below: Figure 3: MORI Relationship Hierarchy

Advocacy

×

Loyalty or Commitment

×

Satisfaction

×

Transaction

×

Trust

×

Awareness

The level of loyalty or commitment implies not only a willingness to repurchase (in the case of a consumer) but also to recommend the business to others if asked. At the highest level of advocacy the individual is so impressed by the company that he or she will recommend it to others without being asked. The company’s own customers and other stakeholders are doing its marketing for them.

Employees

Motivational studies have cited employee relations, a pleasant working environment and sound working practices as having a positive effect on productivity and efficiency

and this can provide increased profitability within the company. MORI research9_found

that 41% of employees satisfied with their jobs will recommend their employer’s products or services without being asked, but that this declines to just 4% of those dissatisfied with their jobs. However it should also be observed that not all attempts to invest in better stakeholder relations can be expected automatically to yield equal or greater returns.

8_{P Hutton, Director, MORI,}_{Using Research to Improve Quality and Service Provision}_{, Paper at SMI Conference}

January 1997

9_{Customer-relationship research, P Hutton, Director, MORI,}_{Using Research to Improve Quality and Service}

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2.3 Portfolio

effects

Figure 4: The effects of ethical investment on a portfolio Ethical policy and approach Fund manager "fit" Missed opportunities Concentration/ churn Research costs Sector and stock effects Commitment Style PORTFOLIO PERFORMANCE Tracking error Volatility Diversification EIRIS, 1999 Figure 4 models the ways in which an ethical investment policy can impact on portfolio performance. The ethical policy of the fund and the fund manager are the key influences on the portfolio performance. The ethical policy and the ethical approach will define the ethical universe from which the fund manager can invest. Of course, for a passively managed fund it is only the ethical criteria and the index construction rules that are the key influences, though very few passively managed ethical tracker funds currently exist.

Diversification

At the portfolio level, the use of ethical criteria to define your investible universe means that there will be some degree of reduced diversification. Financial theory shows that portfolio variability or volatility does not reflect the average variability of its

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components because diversification reduces variability. Brearley and Myers10_show that even a little diversification can provide a substantial reduction in variability, but that you can get most of this benefit with relatively few stocks. The improvement is slight when the number of stocks in a portfolio is increased beyond 20 or 30. Therefore the diversification effects of selecting stocks from an ethically constrained universe are likely to be very tiny indeed.

Tracking error

The tracking error of an ethical fund against a benchmark such as the FTSE All-Share Index compared with that of an unconstrained fund is also likely to be higher. Shorter-term performance may diverge widely from that of funds using more conventional approaches and from the FTSE All-Share Index. But the tracking error may not matter to the investor concerned about the balance of return and risk measured by the volatility of a fund.

Sector and stock effects

The ethical criteria restrictions will have an impact on the size and structure of the resulting investible universe. It is often said that ethical investment funds exhibit a smaller-companies effect since they tend to invest in smaller or medium size companies. Larger companies may be more likely to be ruled out by ethical screening as they tend to be involved in a larger number of areas of which investors might disapprove. Smaller companies may be more volatile than larger companies, which matters in the short term, although a portfolio of smaller companies will diversify away the specific risk of individual stocks.

The ethical universe is often overweight in some sectors such as service sectors, and underweight in others such as tobacco, pharmaceuticals, engineering and banks, depending on the ethical policy applied. In the short term these sectoral effects will come into play as some sectors do better than others. This can have a positive or negative effect depending on the balance of sectors in the portfolio compared with the unconstrained universe. On the plus side, sometimes sectors viewed as unethical will have inherent long-term liabilities, for example the tobacco sector. Overall the likelihood is that individual sectoral effects will balance out, at least in the long term. Missed opportunities

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There will be times when opportunities might be missed because an ethical policy prevents investment in a company that is predicted to perform well.

Fund management

We can also look at the portfolio effects from the fund manager perspective. The ethical investment industry often claims that while assessing a company’s environmental and social record, a better insight into an organisation’s financial performance can be gained. And some behaviour positively viewed from an ethical standpoint, such as the implementation of an environmental management system or good employee relations, can be a proxy for a generally well managed company. Concentration/churn

Some ethical funds claim that because they have fewer companies to invest in, they know them better and are more focused on their activities, and as they are often long-term investors this pays off over time. If ethical funds have fewer companies to invest in and a tendency to invest in them for longer, there will be less churn in the portfolio and hence lower trading costs.

A fund manager’s style and experience may or may not fit with a particular ethical approach. Some styles may suit restrictions better than others or for some fund managers an ethical policy may interfere with their strategy. For example, if an active manager’s strategy calls for an overweighting of chemical stocks, screening may interfere with implementation because of environmental considerations. A possible source of underperformance could therefore be a mismatch between the skills and style of the fund manager, and the requirements of the particular ethical approach adopted.

Increased management costs may impinge on the financial performance of some ethical funds. The cost of additional research into company activities may be passed on by fund managers to the investor. However, some have argued that though screening may represent an extra layer of cost, this is more than compensated for by the high levels of customer retention that ethical funds appear to have.

2.4 Conclusions one can draw

The models show that there are both positive and negative influences that can come into play. The combination of all these factors may have the overall effect of broadly

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similar financial performance. It is not likely that ethical criteria will always lead to outperformance, nor will it always lead to under performance. Those who do believe in a consistently positive ethical investment effect on performance need to explain why a market focused on profit maximisation would overlook a potentially successful strategy for so long.

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3 The EIRIS ethical indices

3.1 Methodology

Our objective in the research described below was to examine the relationship between ethically screened universes and financial performance compared with that of an unconstrained universe, the FTSE All-Share Index. In order to reflect the diversity of criteria used by ethical investors and the different approaches they apply to define their universe of ethical stocks, we chose to create five different indices. We could have created many more but for practical purposes we limited it to five.

These indices were calculated by an established index publisher, who for various reasons does not want to be identified. The constituents were defined by applying the selected ethical criteria to our research database and the index calculation was then done. The ethical criteria and constituents were not revised in light of the performance data; the results here are for the original indices devised.

The universe of companies from which we has drawn the constituents of the following ethical indices is the FTSE All-Share Index excluding the Investment Trusts sector. Investment Trusts were not included because of the difficulty in tracking the ethical status of their underlying investments.

We originally identified the constituents as at the end of May 1998 and the financial performance of each set of companies was then backtracked to December 1990 using standard index calculation methodology. The backtracking of performance was done by starting with those constituents for each index which were in the FTSE All-Share index at the end of December 1990. Any other companies which were in the index at May 1998 were then added in at the point at which they joined the FTSE. Each ethical index begins on 31 December 1990 and is based at 100 at that date. As for the FTSE All-Share Index, each ethical index is the arithmetic weighted average of its constituent securities. The weights correspond to the market capitalisations of the constituent securities. These weights are adjusted for the effect of capitalisation issues and corporate actions.

There was no ethical backtracking for the period from December 1990 to May 1998 - companies which were in the index at May 1998 were assumed to be in the index at December 1990 (or whenever they joined the All-Share Index).

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These indices have been maintained to May 1999. The indices were calculated up to and including 31 December 1998 based on the May 1998 constituents. From the end of 1998 the constituents were updated quarterly to reflect changes to the ethical performance of companies, such as takeovers and disposals of ‘unacceptable’ companies or new annual research data becoming available for an area. When constituents were updated they entered the indices on the first day of that quarter and the previous constituents exited the indices on the last day of the previous quarter (unless they had exited the FTSE prior to this in which case we assumed the same exit date as the FTSE). Where any constituents exited the FTSE following the constituents update ‘end’ dates were set to be consistent with their respective exit dates from the FTSE All-Share Index. The criteria used for each index were also updated in 1999 to reflect the criteria offered to clients in 1999 where there were changes. Where there were changes the nearest equivalent criterion was used. The first two indices use negative criteria only. The constituents are obtained simply by stripping out of the FTSE All-Share companies identified by the selected negative criteria. The third and fifth indices use positive criteria only to select companies. The fourth index, the ethical balanced index, has some negative exclusion criteria and then balances other negative and positive criteria. EIRIS researches companies

against a large number of tightly defined criteria11_{. A broad description of the criteria}

used for each index is described below to give an idea of the approach.

Note: Leavers effect – It should be noted that if you backtrack the FTSE using the same methodology as was used for these five indices it will marginally outperform the published performance data on the FTSE. This is because the backtracked index does not take into account those companies leaving the index during that period. For this reason we would not regard the outperformance of these indices as significant.

3.2 The Charities’ Avoidance Index

This index is based on the ethical criteria a number of charities commonly use for selecting investments. Some of these charities use additional criteria in other areas. The index excludes companies identified by the following activities:

11_{A full description of criteria researched by EIRIS and definitions can be obtained from the 1999 Specialised}

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•

alcohol or tobacco production or gambling (>3% turnover) alcohol or tobacco sale (>10% turnover)

military involvement (sale or production of strategic goods or services for military users including weapons)

pornography (publish, print or wholesale magazines containing pornographic material or distribute cut 18 certificate films or videos)

In May 1999 this index included 534 companies which represented 56% of the FTSE All-Share Index by market value.

Compared with the FTSE All-Share the Charities’ Avoidance Index is overweight in consumer goods and utilities and underweight in resources and general industrials. Figure 5: Charities’ Avoidance Index Total Return Monthly Index Values 1990 – 1999

0 50 100 150 200 250 300 350 400 450

Dec 90 Jun 91 Dec 91 Jun 92 Dec 92 Jun 93 Dec 93 Jun 94 Dec 94 Jun 95 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98 Dec 98

Month and year

Monthly index values

Charities Avoidance FTSE All-Share Index

3.3 The Environmental Damage Avoidance Index

This index excludes companies identified as creating environmental damage of most concern to EIRIS clients. Criteria were selected from each environmental area on the basis of use by EIRIS clients and seriousness of environmental damage.

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This index excludes any companies from the FTSE All-Share Index which are identified by selected criteria under the following headings:

•

greenhouse gas production intensive farming

nuclear power

supply and use of ozone depleting chemicals manufacture and marketing of pesticides

pollution convictions (general pollution and water pollution) PVC manufacture

roadbuilding, fuel retail and vehicle use tropical hardwood use, retail and extraction water pollution - breaches of discharge consents

In May 1999 this index included 507 companies which represented 54% of the FTSE All-Share Index by market value.

Compared with the FTSE All-Share Index the Environmental Damage Avoidance Index is overweight in services and financials and underweight in general industrials, utilities and resources. In fact there are no companies left in the resources sector.

Figure 6: Environmental Damage Avoidance Index Total Return Monthly Index Values 1990 – 1999

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0 50 100 150 200 250 300 350 400 450 500

Dec 90 Jun 91Dec 91 Jun 92Dec 92 Jun 93 Dec 93 Jun 94 Dec 94 Jun 95Dec 95 Jun 96Dec 96 Jun 97Dec 97 Jun 98Dec 98

Month and year

Environmental Damage Avoidance FTSE All-Share Index

3.4 The Responders’ Index

This index identifies those companies which appear to be responding to ethical issues and attempts to reflect the approach of investors who seek to invest in companies whose policies and practices they wish to encourage. This index is constructed by using positive criteria only and therefore no companies are excluded for activities of concern to many ethical investors. Positive criteria were selected under the following areas:

•

community involvement disclosure equal opportunities environmental initiatives training

trade union recognition

Points were allocated from +1 to +3 for each criterion according to its significance and how many companies were identified. For example, a criterion such as energy efficiency certification where few companies achieve the standard was weighted more

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highly than one such as having an environmental statement where many companies achieve the standard. Those companies scoring +5 or more in total were selected as the constituent companies of the index.

In May 1999 this index included only 235 companies, considerably less than the previous two indices but by market value it includes proportionately more at 74% of the total. As we might expect the Responders’ Index is predominantly made up of the larger companies.

Looking at the sectoral structure, it is underweight in services, basic industries and financials and overweight in resources and consumer goods.

Figure 7: Responders’ Index Total Return Monthly Index Values 1990-1999

0 50 100 150 200 250 300 350 400 450

Dec 90 Jun 91Dec 91 Jun 92Dec 92 Jun 93Dec 93 Jun 94Dec 94 Jun 95Dec 95 Jun 96Dec 96 Jun 97Dec 97 Jun 98Dec 98

Month and year

Responders FTSE All-Share Index

3.5 The Ethical Balanced Index

This index is constructed by first identifying activities of concern to most EIRIS clients and removing companies involved in them, and secondly by weighting a number of

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positive and negative criteria commonly used and selecting companies that score two or more overall. The weightings of criteria reflected the level of involvement and use by clients.

The exclusion criteria included:

•

animal testing services gambling (>10% turnover)

weapons production, nuclear weapons involvement and major arms exporters

operators of nuclear power stations

manufacture of ozone depleting chemicals marketing of pesticides with banned ingredients

pornography (publish, print or wholesale magazines that CPC says contain pornographic material)

irresponsible third world marketing tobacco production (>10% turnover)

tropical hardwood extraction/use of large quantities

Negative criteria used to rate companies include criteria from the following areas:

advertising complaints, alcohol, animal testing, gambling, greenhouse gases, health & safety convictions, human rights, intensive farming, military , nuclear power, ozone depleting chemicals, pesticides, political donations, pollution convictions, pornography, PVC, roads, third world, tobacco, tropical hardwood, water pollution.

Positive criteria used to rate companies include criteria from the following areas:

community involvement, disclosure, environmental initiatives, equal opportunities, and positive products & services.

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0 50 100 150 200 250 300 350 400 450

Month and year

Ethical Balanced FTSE All-Share Index

In May 1999 this index included 340 companies which accounted for 47% of the FTSE All-Share index by market value. The Ethical Balanced Index was the most restrictive index in terms of the market capitalisation left.

The index is heavily overweight in services and overweight in financials and utilities. It is underweight in consumer goods, resources and general industrials.

3.6 The Environmental Management Index

This index identifies companies that have made progress on environmental management. The indicators used for environmental management include:

•

corporate environmental statements environmental reports

environmental reporting awards

adoption of environmental management systems such as EMAS or ISO14001

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This index does not include any measurement of environmental damage.

Points were allocated from +1 to +4 for each indicator used according to its significance and the number of companies identified. Those companies scoring a total of more than 3 points were selected as the constituent companies of the index. It should be noted that this index does not include any measure of environmental damage.

In May 1999 this index included 117 companies which accounted for 57% of the FTSE All-Share index by market value. It is the smallest index of the five in terms of the number of constituents but again many of these are larger companies.

Figure 9: Environmental Management Index Total Return Monthly Index Values 1990-1999 0 50 100 150 200 250 300 350 400 450

Month and year

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The environmental management index is overweight in resources, consumer goods and utilities. It is very underweight in financials and underweight in services.

3.7 Results

Table 1: Index sizes as at 31 May 1999

Number of FTSE All-Share Companies % of FTSE All-Share Index by market value

Charities’ Avoidance Index 534 56%

Environmental Damage Avoidance Index 507 54%

Responders’ Index 235 74%

Ethical Balanced Index 340 47%

Environmental Management Index 117 57%

FTSE All-Share Index= 817= 100%

Table 2: Industry group structure May 1999

Industry Group Charities’ Avoidance Environ-mental Damage Avoidance Responders Ethical Balanced Environ-mental Mgement FTSE All-Share Resources 1.2% 0.0% 15.4% 0.3% 19.5% 11.6% Basic Industries 4.9% 1.6% 2.2% 2.1% 3.4% 3.7% General Industrials 1.1% 1.0% 4.6% 0.6% 4.7% 4.5% Cyclical Consumer Goods 0.2% 0.4% 0.8% 0.5% 1.0% 0.7% Non-Cyclical Consumer Goods 25.3% 16.6% 21.8% 9.1% 28.0% 17.3% Cyclical Services 22.0% 21.7% 13.2% 21.2% 8.9% 16.9% Non-Cyclical Services 11.2% 21.5% 11.7% 21.0% 11.4% 12.6% Utilities 8.2% 2.3% 5.8% 8.5% 7.5% 4.6% Information Technology 1.4% 2.3% 0.5% 1.5% 0.0% 1.4% Financials 24.5% 32.6% 24.2% 35.2% 15.6% 26.7% TOTAL 100.0% 100.0% 100.0% 100.0% 100.0% 100%

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The industry group structure of each index is very different. Table 2 illustrates the sectors which are under or overweight for each index compared with the FTSE.

Table 3: Cumulative performance statistics 1990 -1999 (Total return)

Year End Charities’ Avoidance Environmental Damage Avoidance Responders Ethical Balanced Environmental Management FTSE All-Share 1991 26 28 23 17 25 21 1992 51 53 51 44 50 46 1993 88 94 91 91 83 87 1994 77 81 79 76 75 75 1995 117 124 122 114 109 118 1996 150 164 156 149 137 154 1997 218 232 232 213 204 214 1998 275 295 285 267 260 258 May 99 291 334 313 297 282 291

Figure 10: Total annual return compared with the FTSE All-Share Index 1990-1999

0.08% 1.61% 0.53% _0.34% -0.61% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% Charities Avoidance Environmental Damage Avoidance Responders Ethical Balanced Environmental Management

In the period from December 1990 to May 1999 three of the five indices outperformed the FTSE All-Share Index. The best performer over this period was the Environmental Damage Avoidance Index. The only index to underperform the FTSE was the Environmental Management Index.

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Figure 11: Annual tracking error 1990 -1999 3.3% 3.2% 2.5% 4.0% 3.9% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% Charities Avoidance Environmental Damage Avoidance

Responders Ethical Balanced Environmental

Management

Tracking errors of these indices is not particularly high, but it is clear that investors would need to accept a variance from the FTSE All-Share Index of between 2 and 4%.

Table 4: Correlation between indices and FTSE All-Share Index

Beta R2

Charities’ Avoidance Index 0.89 94.2%

Environmental Damage Avoidance Index 0.98 94.4%

Responders’ Index 0.96 96.6%

Ethical Balanced Index 0.97 91.6%

Environmental Management Index 0.86 92.3%

The beta, which measures the relative volatility of each index compared with the FTSE All-Share Index, was in the range 0.86 to 0.98 for the five indices. The R-squared ranged from 91.6% to 96.6%.

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Figure 12: Annual index volatility 12.4% 13.7% 13.2% 13.7% 12.1% 13.5% 11.0% 11.5% 12.0% 12.5% 13.0% 13.5% 14.0% Charities Avoidance Environmental Damage Avoidance Responders Ethical Balanced Environmental Management FTSE All-Share Index

Annual index volatility for two of these indices was marginally higher than that for the FTSE All-Share Index, whilst three of the indices showed lower volatility.

3.8 Conclusions

This exercise illustrates the diversity of approaches that could be taken by ethical investors. Despite the large differences in the size and sectoral structure of each index their performance is remarkably similar to the FTSE All-Share Index over the eight and a half year time period they were calculated. These indices had tracking errors of between 2% and 4% but volatility for three of the five indices was lower than that of the FTSE and the other two had only marginally higher volatility. This research indicates that investment universes constructed on an ethical basis can provide a balance of risk and return which doesn’t look materially different from the FTSE All-Share Index.

3.9 Other ethical indices

3.9.1 Domini 400 Social Index (DSI)

This index was launched in the USA in 1990 by Kinder Lydenberg Domini (KLD). It is a cap-weighted index of 400 common stocks modelled on the S&P 500. KLD took the S&P 500 and applied negative screens first, then qualitative positive screens to get approximately 250 companies. Then approximately 100 large cap companies not in the S&P 500 were added which passed the exclusionary screens and in most cases

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“exhibited an outstanding record in one of the qualitative screening areas”. This was to give it a broad representation of sectors and to find companies which were particular models of corporate behaviour. Then added 50 companies with exceptional social characteristics. KLD reports in mid-1998 that the DSI has outperformed the S&P 500 on a total return basis and on a risk-adjusted basis since its inception in May 1990. The portfolio turnover is only 6-8% in a typical year.

3.9.2 NPI Social Index

This index was launched in May 1998. It was constructed to reflect the capitalisation and Industry Group structure of the FTSE All-Share Index. The constituents include 150 companies and 8 investment trusts. NPI selected companies by assessing strengths and weaknesses in managing social and environmental aspects of their business. The index is being calculated by FTSE International on a daily basis. Over the period from January 1990 to January 1998 the NPI Social Index outperformed the FTSE. NPI have now launched a tracker fund (open ended investment company) based on the Social Index.

3.9.3 WM Indices

WM maintain a FTSE All-Share ex-Vices Index for their charity clients which excludes the gambling, tobacco and alcohol sectors which is a total return index. WM also maintain a FTSE All-Share Ethical Restraints Index which is a capital only index. As at mid 1996 the Ethical Restraints Index comprised the FTSE All-Share Index with approximately 50 stocks stripped out, mainly for alcohol, gambling, tobacco and arms involvement. See section 5.2.4 for further details of these indices.

3.9.4 Nature Equity Index

This index of just 20 environmental stocks from around the world was established in 1997 by Oko Invest in Austria.

3.9.5 Calvert Social Investment Fund Managed Index Portfolio

This US fund is significant in that it is the first socially screened index fund designed to track a recognised stock market index, the Russell 1000 Index. Calvert Group first screen the Index to find stocks which meet the Portfolio’s social and environmental positive and negative screening criteria. Then State Street Global Advisors (SSgA) use a quantitative model to construct a basket of stocks with portfolio characteristics

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similar to the Russell Index. The final portfolio gives greater weight to stocks which SsgA identify as having the greatest performance potential. The annual tracking error of this fund is approximately 2.5%, which is in general higher than a normal non-ethically screened tracker fund, but lower than an actively managed non tracker fund.

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4 EIRIS research into the financial performance

of ethical unit trusts

4.1 Purpose of the study and approach taken

The purpose of this study is to address the question “do funds with ethical criteria perform differently in practice to other funds over the longer term, and if so how?” The funds examined are the 15 UK unit trusts with ethical criteria that had 5-year track records at the end of June 1998. The approach taken to longer-term performance has been to look at every 5-year period ending in June or December back from June 1998 over the life of each fund.

Longer term performance has been chosen for two reasons: firstly because that is what the customers of “retail” products such as unit trusts might be expected to be looking at, particularly in view of the charging arrangements which make shorter term investment unwise. Secondly, one of the attractions of looking at “real” products rather than theoretical studies is the question of how administrative costs contribute to the results. In principle, such costs might appear in either front-end, or regular annual management charges. Using five-year offer-to-bid figures should capture such effects regardless of the choices of individual firms as to how to split costs between the two types of charges.

4.2 The funds examined

The fifteen funds examined are set out below. A total of 149 rolling 5-year periods are covered by the study, although clearly some funds have more of these than others.

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Table 5: Funds covered, showing sectors, first period covered and number of 5-year periods

Name of fund (July 98) Sector Start of

first 5-year period

No of 5-year periods

Abbey Ethical UK Growth 01/01/88 12 Allchurches Amity UK Growth 01/07/88 11 Credit Suisse Fellowship UK Growth 01/01/92 14 Friends Provident Stewardship UK Growth 02/07/84 19 Scottish Equitable Ethical UK Growth 03/07/89 9 Sovereign Ethical UK Growth 03/07/89 9

TSB Environmental Investor UK Growth 03/07/89 9

Friends Provident Stewardship Inc UK Income 01/01/88 12

Aberdeen Prolific Ethical International Growth 01/01/93 2 CIS Environ International Growth 01/07/90 7 City Financial Acorn Ethical International Growth 02/01/89 10 Clerical Med Evergreen International Growth 02/07/90 7 Framlington Health International Growth 01/07/87 13 Jupiter Ecology International Growth 01/07/88 11 NPI Global Care International Growth 01/01/92 4

Total 149

4.3 Problems to be overcome

Ideally, one might like an answer to the fundamental question of how ethical criteria affected financial performance that was not too dependent upon either:

• the skills, strategy or house style of any one fund manager or fund management

house

• the particular economic circumstances of the period studied, for example

circumstances favourable or unfavourable to smaller stocks

So one might hope for at least a dozen funds with 10-15 year records, all following the same approach to ethical investment. Alternatively, one might study a larger number of funds that had between them two or three clearly differentiated approaches to ethical investment so that within each group the data can be satisfactorily added together or averaged without aggregating apples and pears.

Unhappily (for this study anyway) such conditions do not apply. The fact that each fund has a tendency to adopt its own approach to ethical investment also raises

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doubts about the wisdom of seeking a general answer to the question posed in any case. Different approaches to integrating ethical and financial considerations must affect financial performance in different ways and so, on at least one level, our original question is not a very sensible one.

An additional complication with the present sample is how to aggregate performance across funds with different geographical or other investment universes or financial objectives. Half the funds are international, half are UK, and one of the UK ones falls into the “income” category, since it aims to earn high income, while all the others are looking principally for capital growth. Two of the funds also focus on particular sectors (Health and Environmental Technology/Utilities) rather than the whole of their respective geographical markets.

4.4 The ways these problems have been tackled

4.4.1 The diversity of approaches

The range of approaches means that in practice the hope of a general answer to the fundamental question posed must be abandoned. Instead we must recognise that the study examines how these particular 15 funds have performed, and be aware that other approaches (or a different balance of approaches in the sample) would have produced different results.

4.4.2 Different geographical and sector universes, and different financial objectives

The approach used in this study to compare funds with different investment universes and financial objectives has been twofold:

• Firstly the performance of each fund is compared with the average performance of

all the funds without ethical criteria in the same financial sector. The sectors used are those provided in the Micropal data for funds existing at the end of June 1998. These comparative performance figures can then be added up across the three sectors (to increase the volume of data) while maintaining the principle that each fund is compared against its peers.

• Secondly the overall totals are presented both with and without the two funds that

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technology/Utilties) within their particular geographical universe, rather than across the whole of that particular geographical area.

4.4.3 The lack of significant numbers of funds over the whole period studied

The sample of fifteen funds has only one which has a fifteen year record, the Friends Provident Stewardship Fund, and some of the other funds have only two or three five year records. So two basic approaches have been taken to aggregating the performance of the 15 funds:

a) Give each 5-year time period equal weight, regardless of how many funds were in existence at the time.

This means firstly taking each of the 5 year periods and producing a figure for the average performance of all the funds in existence during that particular period. Then an equally weighted average was taken of all those 5-year period figures to produce an overall average.

This approach will give greater emphasis to the performance of those funds that have been around the longest, and in particular to their performance in their earlier years. b) Give each fund equal weight, regardless of the time period over which it has existed.

This means first taking each fund and producing figures for its average 5-year performance (using as many 5-year records as are available for that fund). For this purpose each fund is compared only with those funds without ethical criteria in the same sector which have existed at least as long as the fund in question. This approach makes it possible to compare the standard deviation of 5-year returns with those other funds as a measure of the stability of the 5-year returns (one possible measure of risk). Once you have figures for each fund, you can take an equally weighted average of those funds to produce an overall average for the 15 funds. This approach will give greater emphasis to more recent economic conditions, because circumstances in the earlier years of the study have no influence upon funds that had not been launched at the time.

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It could also be argued that the performance of some funds should be given greater weight than others. For example, if one is wants to know how the typical ethical investor has fared, it might be reasonable to give greater weight to the financial performance of those funds with a larger share of the ethical investment market than to smaller ones whose performance affects fewer ethical investors. While this approach has not been developed in any detail, figures are presented separately for those funds that were the largest at the end of the period.

4.5 How has the data been analysed?

The Micropal figures used are 5-year offer to bid figures showing the effect of investing £1,000 over the 5 years in question. For the purposes of this study these figures were first converted into annualised percentage growth figures.

Secondly those annualised figures were then compared with all the funds without ethical criteria in the same sector in three ways:

• out- or under-performance compared with the average (mean) fund in that sector,

being the difference in the respective percentage growth figures

• out- or under-performance (on the same basis) compared with the median fund in

that sector (i.e. the fund which beat exactly 50% of the other funds in the particular sector)

• the percentile rank of the fund itself (i.e. what percentage of the other funds in its

sector did it beat)

Both average and median comparisons were used because sometimes the average figures appear significantly affected by particularly good (or bad) performance of the funds at the top and bottom of the tables. This is particularly true when some funds with very different objectives (like recovery situation, or other high-risk approaches) are grouped into a broader sector, and sometimes perform very differently.

All three sets of figures can then be aggregated across sectors in the two ways described above (by fund and by time period).

It is worth noting that almost all unit trusts (ethical or otherwise) fall behind the relevant market index (for example the FTSE All-Share Index) over time because of

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the effect of charges upon performance. Comparing ethical investment funds with other unit trusts means that there are charges in both sets of figures.

4.6 Results

Table 6: The results for each fund compared with the average and median fund in the sector

Name of fund (July 98) Number

of 5-year periods in study Sector average 5-year returns Difference in fund's average returns against the average Sector median 5-year returns Difference in fund's average returns against the median UK growth sector= Abbey Ethical 12 10.07 -0.44 10.10 -0.46 Allchurches Amity 11 10.49 -1.80 10.27 -1.58 Credit Suisse Fellowship (*) 14 9.05 -1.39 9.10 -1.43 Friends Provident Stewardship(*) 19 10.32 0.01 9.87 0.46 Scottish Equitable Ethical(*) 9 10.95 -0.62 10.64 -0.32 Sovereign Ethical 9 10.95 -1.58 10.64 -1.28 TSB Environmental Investor 9 10.95 -0.17 10.64 0.14

UK income sector=

Friends Provident Stewardship Inc 12 10.37 -2.22 10.16 -2.01

International growth sector=

Aberdeen Prolific Ethical 2 11.06 -0.41 10.53 0.11 CIS Environ(*) 7 12.24 0.70 11.34 1.60 City Financial Acorn Ethical 10 11.34 -1.87 10.28 -0.81 Clerical Medical Evergreen 7 12.24 -6.65 11.34 -5.74 Framlington Health 13 10.35 10.82 9.88 11.28 Jupiter Ecology 11 11.14 -1.12 10.27 -0.25 NPI Global Care(*) 4 12.54 -0.65 11.66 0.22

All ethical funds 149 -0.49 -0.01

All excluding Health & Evergreen 129 -0.89 -0.43 Larger funds (*) excluding Health &

Evergreen

53 -0.39 0.11

Table 6 notes:

• The sector average columns differ within each sector, because each fund is being compared with all the other funds that have existed at least as long as it has. This means that the comparison is with different funds over different periods, depending on the life-span of each ethical investment fund.

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• The difference in fund returns means, for example, that Abbey Ethical had an average return of 0.44% less than the sector average of 10.07% (its average being 9.63%) over the twelve 5-year periods of its life-span.

The totals for all funds at the bottom of the table show that, on average, these funds (excluding the two sector funds, Framlington Health and Clerical Medical Evergreen, had 5-year returns of 0.89% less than the average, and 0.43% less than the median fund in their respective sectors. The largest five funds at the end of the study (being those with (*) after their names), however, had an average of 0.11% better than the median fund.

Table 7: Comparison of percentile performance, standard deviation in returns, and the percentile performance of "risk" measured in terms of standard deviation

Name of fund (July 98) Number

of 5-year periods in study Average percentil e of 5-year returns Standard deviation of fund's returns Sector average standard deviation Percentile of sector with lower "risk" UK growth sector Abbey Ethical 12 43% 2.05% 4.05% 1% Allchurches Amity 11 24% 2.51% 3.99% 10% Credit Suisse Fellowship(*) 14 42% 8.32% 4.68% 97% Friends Provident Stewardship(*) 19 47% 5.36% 5.80% 56% Scottish Equitable Ethical(*) 9 40% 2.91% 4.00% 24% Sovereign Ethical 9 31% 4.55% 4.00% 75% TSB Environmental Investor 9 50% 3.76% 4.00% 54%

UK income sector

Friends Provident Stewardship Inc 12 25% 3.31% 3.33% 59%

International growth sector

Aberdeen Prol Ethical 2 52% 0.47% 0.58% 50% CIS Environ (*) 7 64% 1.61% 2.89% 1% City Financial Acorn Ethical 10 37% 2.79% 3.65% 10% Clerical Medical Evergreen 7 1% 2.84% 2.89% 50% Framlington Health 13 97% 6.34% 4.81% 90% Jupiter Ecology 11 44% 3.55% 3.57% 54% NPI Global Care (*) 4 50% 0.61% 2.04% 4%

All ethical funds 149 43% 42%

All excluding Health & Evergreen 129 42% 38% Larger funds (*) excluding Health &

Evergreen 53 49% 36%

Table 7 notes:

• The average percentile of 5-year returns means the average of the percentile performance in each 5-year period. The percentile performance means the proportion of the funds in the same sector that the particular fund beat. So, for example, Abbey Ethical beat 43% of the funds in its sector on average over all the twelve 5-year periods examined.

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• The standard deviation of the 5-year returns gives an indication of how variable the 5-year returns were across the period covered. This has been termed "risk" for the purposes of this table.

The comparison of the standard deviation with the same figure for all other funds in the sector begins to show that ethical investment funds may well be less risky than conventional funds.

The two largest exceptions to that on this table are the Credit Suisse Fellowship fund and the Framlington Health fund. The Framlington Health fund is genuinely more volatile, but the Credit Suisse result arises because consistent under-performance in the earlier part of the study became consistent out-performance towards the end. This certainly does reflect a spread of results, but not the sort of "risk" many of their longer-term investors would now object to!

The percentile of sector with lower "risk" shows what proportion of the funds in the same sector over the same period as each fund had a lower standard deviation in their returns. So, for example, only 1% of funds in the UK growth sector had a standard deviation lower than Abbey Ethical's 2.05% figure (the average over the same period amongst funds which have existed as long as Abbey Ethical being 4.05%).

Overall this table shows the thirteen funds (excluding Framlington Health and Clerical Medical Evergreen) having better returns on average than 42% of other funds in the relevant sectors, with only 38% of such other funds having lower "risk". The largest five funds did better than 49% of their sectors on return, and only 36% had lower "risk".