Does Ethical Investment Pay

Transcription

Does Ethical Investment Pay?
EIRIS research and other studies of ethical
investment and financial performance
Ros Havemann & Peter Webster
September 1999
Copyright EIRIS 1999. All rights reserved. No paragraph or other part
of this publication may be reproduced or transmitted in any form or
by any means, including photocopying and recording, without the
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.
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.
Contents
EXECUTIVE SUMMARY........................................................................................................................1
1
BACKGROUND ..............................................................................................................................3
Figure 1: Growth of ethical unit and investment trusts 1989 - 1999..........................................................3
2
MODELLING THE PERFORMANCE EFFECTS OF ETHICAL CRITERIA ...................................6
2.1 INTRODUCTION ..................................................................................................................................6
2.2 COMPANY EFFECTS ...........................................................................................................................6
Figure 2: The effects of ethical behaviour on company share price .........................................................6
Figure 3: MORI Relationship Hierarchy ...................................................................................................9
2.3 PORTFOLIO EFFECTS .......................................................................................................................10
Figure 4: The effects of ethical investment on a portfolio .......................................................................10
2.4 CONCLUSIONS ONE CAN DRAW .........................................................................................................12
3
THE EIRIS ETHICAL INDICES ....................................................................................................14
3.1 METHODOLOGY ...............................................................................................................................14
3.2 THE CHARITIES’ AVOIDANCE INDEX ..................................................................................................15
Figure 5: Charities’ Avoidance Index Total Return Monthly Index Values 1990 – 1999 .........................16
3.3 THE ENVIRONMENTAL DAMAGE AVOIDANCE INDEX ............................................................................16
Figure 6: Environmental Damage Avoidance Index Total Return Monthly Index Values 1990 – 1999 ...17
3.4 THE RESPONDERS’ INDEX ...............................................................................................................18
Figure 7: Responders’ Index Total Return Monthly Index Values 1990-1999.........................................19
3.5 THE ETHICAL BALANCED INDEX ........................................................................................................19
Figure 8: Ethical Balanced Index Total Return Monthly Index Values 1990-1999 ..................................20
3.6 THE ENVIRONMENTAL MANAGEMENT INDEX ......................................................................................21
Figure 9: Environmental Management Index Total Return Monthly Index Values 1990-1999 ................22
3.7 RESULTS ........................................................................................................................................23
Table 1: Index sizes as at 31 May 1999 ................................................................................................23
Table 2: Industry group structure May 1999 ..........................................................................................23
Table 3: Cumulative performance statistics 1990 -1999 (Total return) ..................................................24
Figure 10: Total annual return compared with the FTSE All-Share Index 1990-1999.............................24
Figure 11: Annual tracking error 1990 -1999 ..........................................................................................25
Table 4: Correlation between indices and FTSE All-Share Index..........................................................25
Figure 12: Annual index volatility............................................................................................................26
3.8 CONCLUSIONS ................................................................................................................................26
3.9 OTHER ETHICAL INDICES ..................................................................................................................26
3.9.1
Domini 400 Social Index (DSI) .......................................................................................26
3.9.2
NPI Social Index .............................................................................................................27
3.9.3
WM Indices .....................................................................................................................27
3.9.4
Nature Equity Index ........................................................................................................27
3.9.5
4
Calvert Social Investment Fund Managed Index Portfolio .............................................27
EIRIS RESEARCH INTO THE FINANCIAL PERFORMANCE OF ETHICAL UNIT TRUSTS ....29
4.1 PURPOSE OF THE STUDY AND APPROACH TAKEN ...............................................................................29
4.2 THE FUNDS EXAMINED .....................................................................................................................29
Table 5: Funds covered, showing sectors, first period covered and number of 5-year periods .............30
4.3 PROBLEMS TO BE OVERCOME ..........................................................................................................30
4.4 THE WAYS THESE PROBLEMS HAVE BEEN TACKLED ............................................................................31
4.4.1
The diversity of approaches ...........................................................................................31
4.4.2
Different geographical and sector universes, and different financial objectives ............31
4.4.3
The lack of significant numbers of funds over the whole period studied........................32
4.5 HOW HAS THE DATA BEEN ANALYSED?..............................................................................................33
4.6 RESULTS ........................................................................................................................................34
Table 6: The results for each fund compared with the average and median fund in the sector..............34
Table 7: Comparison of percentile performance, standard deviation in returns, and the percentile
performance of "risk" measured in terms of standard deviation .............................................................35
Table 8: The results for each period covered ........................................................................................37
Table 9: The percentile performance of each fund against all other funds in the same sector at the same
time ........................................................................................................................................................38
4.7 SUPPLEMENTARY RESEARCH INTO RISK AS MEASURED BY VOLATILITY OF MONTHLY RETURNS ..............39
Table 10: Annualised standard deviation of monthly returns for the 36 month period ending as specified
...............................................................................................................................................................40
4.8 CONCLUSIONS AND IMPLICATIONS ....................................................................................................40
4.9 THE NEED FOR FURTHER RESEARCH .................................................................................................44
5
OTHER STUDIES OF FINANCIAL PERFORMANCE .................................................................45
5.1 OVERVIEW ......................................................................................................................................45
5.2 RESEARCH INTO ACTUAL PORTFOLIO PERFORMANCE .........................................................................45
5.2.1
Introduction .....................................................................................................................45
5.2.2
The Investment Performance of UK ‘Ethical’ Trusts - Luther, Matatko, Corner (1992)..46
5.2.3
Ethical Unit Trust Financial Performance: Small Company Effects & Fund Size Effects Gregory, Matatko, Luther (1996)...................................................................................46
5.2.4
Is there a Cost to Ethical Investing - WM Company (1997) ...........................................46
5.3 RESEARCH INTO THEORETICAL PORTFOLIO PERFORMANCE ................................................................47
5.3.1
Introduction .....................................................................................................................47
5.3.2
Divestment of South African equities: How risky? – Rudd (1979)..................................48
5.3.3
South African Divestment: The Investment Issues - Wagner, Emkin & Dixon (1984) ...48
5.3.4
The Cost of Imposing an Ethical Constraint on an Investment Portfolio – Woodall (1986)
........................................................................................................................................49
5.3.5
The Financial Performance of Ethical Investments - EIRIS/BARRA (1989) ..................50
5.3.6
EIRIS/BARRA (1993 - unpublished)...............................................................................51
5.3.7
The Private Cost of Socially Responsible Investing - Diltz (1995) .................................51
5.3.8
Environmental and Financial Performance: Are They Related? - Cohen, Fenn & Naimon
(1995)..............................................................................................................................51
5.3.9
Just Say No? The Investment Implications of Tobacco Divestiture - Kahn, Lekander &
Leimkuhler (1997)...........................................................................................................52
5.3.10
Additional Evidence on the Cost of Being Socially Responsible in Investing – Guerard
(1997)..............................................................................................................................52
5.3.11
Expanding Socially Screened Portfolios: An Attribution Analysis of Bond Performance Antonio, Johnsen & Hutton (1997) .................................................................................52
5.4 RESEARCH INTO IMPACT OF ETHICAL BEHAVIOUR BY COMPANIES........................................................53
5.4.1
Introduction .....................................................................................................................53
5.4.2
Does it Pay to be Green? An Empirical Examination of the Relationship between
Emission Reduction and Firm Performance - Hart & Ahuja (1996)................................53
5.4.3
Financial Returns of Public ESOP Companies: Investor Effects vs. Manager Effects Conte, Blasi, Kruse & Jampani (1996) ...........................................................................54
5.4.4
The Impact of Environmental Management on Firm Performance - Klassen &
McLaughlin (1996) ..........................................................................................................54
5.4.5
A Quantitative Analysis of the Impact of Unethical Behaviour by Publicly Traded
Corporations - Gunthorpe (1997) ...................................................................................55
5.4.6
Finding the Link Between Stakeholder Relations & Quality of Management - Waddock &
Graves (1997).................................................................................................................55
5.4.7
Does Improving a Firm’s Environmental Management System and Environmental
Performance Result in a Higher Stock Price? - Feldman, Soyka, Ameer (1997) ..........56
5.4.8
A Resource-Based Perspective on Corporate Environmental Performance and
Profitability - Russo & Fouts (1997)................................................................................56
5.4.9
The Link between Company Environmental & Financial Performance - David Edwards
(1998)..............................................................................................................................56
5.4.10
Pensions and the Environment - Nottinghamshire County Council (1998)....................57
5.4.11
Corporate Performance is Closely Linked to a Strong Ethical Commitment - Verschoor
(1998)..............................................................................................................................58
6
BIBLIOGRAPHY ...........................................................................................................................60
7
GLOSSARY OF TERMS ..............................................................................................................62
APPENDIX 1 Total Return Monthly Index Values Dec 1990 - May 1999 ...........................................65
Executive summary
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 "suboptimal" 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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© EIRIS, September 1999
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.
-2-
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
2500
2000
1500
£m
1000
500
0
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
2 EIRIS/NOP Solutions survey of pension scheme members, June 1999
-3-
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 threequarters 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
ethical investment, even if it performed badly or was ethically ineffective”.
-4-
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.
3
Webley, Lewis & Mackenzie, Loyalty in Ethical Investment: An Experimental Approach
-5-
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
Cash flow
Government
legislation
Company costs
- productivity
- costs
- supplier relations
COMPANY
- strategy
Customers
Company sales
- price
- volume
- market share
Shareholders
Cost of capital
SHARE PRICE
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
5
John Kay, Good Business, March 1998
Centre for Tomorrow’s Company, The Inclusive Approach and Business Success
-6-
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,
Blumberg, Blum and Korsvold
-7-
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,
1998
-8-
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
Provision, Paper at SMI Conference January 1997
-9-
2.3
Portfolio effects
Figure 4: The effects of ethical investment on a portfolio
Ethical policy
and approach
Diversification
Volatility
Tracking
error
Concentration/
churn
Sector and
stock effects
Missed
opportunities
PORTFOLIO
PERFORMANCE
Style
Commitment
Research
costs
Fund manager
"fit"
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
- 10 -
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. Shorterterm 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
10
Principles of Corporate Finance, Brearley & Myers 1996
- 11 -
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 longterm 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
- 12 -
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.
- 13 -
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 AllShare 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).
- 14 -
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
Client Questionnaire and EIRIS Issues and Definitions publication.
- 15 -
•
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
Charities Avoidance
FTSE All-Share Index
450
400
Monthly index values
350
300
250
200
150
100
50
0
De
c
90
Ju
n
91
De
c
91
Ju
n
92
De
c
92
Ju
n
93
De
c
93
Ju
n
94
De
c
94
Ju
n
95
De
c
95
Ju
n
96
De
c
96
Ju
n
97
De
c
97
Ju
n
98
De
c
98
Month and year
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.
- 16 -
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
- 17 -
Environmental Damage Avoidance
500
450
400
350
300
250
200
150
100
50
0
c
De
3.4
90
n
Ju
91
c
De
91
n
Ju
92
c
De
92
n
Ju
93
c
De
93
n
Ju
94
94
98 c 98
97 c 97
96 c 96
95 c 95
c
n
n
n
n
Ju
Ju
Ju
Ju
De
De
De
De
De
Month and year
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
- 18 -
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
Responders
450
400
350
300
250
200
150
100
50
0
De
3.5
c
90
Ju
n
91
De
c
91
Ju
n
92
De
c
92
Ju
n
93
De
c
93
Ju
n
94
94
95 c 9 5
96 c 9 6
97 c 9 7
98 c 9 8
c
n
n
n
n
Ju
Ju
Ju
Ju
De
De
De
De
De
Month and year
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
- 19 -
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.
Figure 8: Ethical Balanced Index Total Return Monthly Index Values 1990-1999
- 20 -
Ethical Balanced
450
400
350
300
250
200
150
100
50
0
De
c
90
Ju
n
91
De
c
91
Ju
n
92
De
c
92
Ju
n
93
De
c
93
Ju
n
94
94
98 c 9 8
97 c 9 7
96 c 9 6
95 c 9 5
c
n
n
n
n
Ju
Ju
Ju
Ju
De
De
De
De
De
Month and year
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
•
alternative energy development and energy efficiency certification
- 21 -
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 19901999
Environmental Management
450
400
350
300
250
200
150
100
50
0
De
c
90
Ju
n
91
De
c
91
Ju
n
92
De
c
92
Ju
n
93
De
c
93
Ju
n
94
94
95 c 9 5
96 c 9 6
97 c 9 7
98 c 9 8
c
n
n
n
n
Ju
Ju
Ju
Ju
De
De
De
De
De
Month and year
- 22 -
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
534
% of FTSE AllShare Index by
market value
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%
Charities’ Avoidance Index
Table 2: Industry group structure May 1999
Industry Group
Resources
1.2%
Environmental
Damage
Avoidance
0.0%
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
Non-Cyclical
Consumer Goods
Cyclical Services
0.2%
0.4%
0.8%
0.5%
1.0%
0.7%
25.3%
16.6%
21.8%
9.1%
28.0%
17.3%
22.0%
21.7%
13.2%
21.2%
8.9%
16.9%
Non-Cyclical
Services
Utilities
11.2%
21.5%
11.7%
21.0%
11.4%
12.6%
8.2%
2.3%
5.8%
8.5%
7.5%
4.6%
Information
Technology
Financials
1.4%
2.3%
0.5%
1.5%
0.0%
1.4%
24.5%
32.6%
24.2%
35.2%
15.6%
26.7%
100.0%
100.0%
100.0%
100.0%
100.0%
100%
TOTAL
Charities’
Avoidance
- 23 -
Responders
Ethical
Balanced
Environmental
Mgement
FTSE
AllShare
15.4%
0.3%
19.5%
11.6%
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
1991
26
Environmental
Damage
Avoidance
28
Responders
Ethical
Balanced
Environmental
Management
23
17
25
FTSE
AllShare
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
2.0%
1.61%
1.5%
1.0%
0.5%
0.53%
0.34%
0.08%
-0.61%
0.0%
-0.5%
-1.0%
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.
Full monthly total return index data (capital plus income) is shown in Appendix 1.
- 24 -
Figure 11: Annual tracking error 1990 -1999
4.0%
4.5%
4.0%
3.3%
3.9%
3.2%
3.5%
2.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Charities
Avoidance
Responders
Environmental
Damage
Avoidance
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 Rsquared ranged from 91.6% to 96.6%.
- 25 -
Figure 12: Annual index volatility
13.7%
14.0%
13.5%
13.2%
13.5%
13.0%
13.7%
12.4%
12.1%
12.5%
12.0%
11.5%
11.0%
Charities
Avoidance
Environmental Responders
Damage
Avoidance
Ethical
Balanced
Environmental
FTSE AllManagement 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 AllShare 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
- 26 -
“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
- 27 -
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 nonethically screened tracker fund, but lower than an actively managed non tracker fund.
- 28 -
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.
- 29 -
Table 5: Funds covered, showing sectors, first period covered and number of 5-year
periods
4.3
Name of fund (July 98)
Sector
Start of
first 5-year
period
No of
5-year
periods
Abbey Ethical
Allchurches Amity
Credit Suisse Fellowship
Friends Provident Stewardship
Scottish Equitable Ethical
Sovereign Ethical
TSB Environmental Investor
UK Growth
UK Growth
UK Growth
UK Growth
UK Growth
UK Growth
UK Growth
01/01/88
01/07/88
01/01/92
02/07/84
03/07/89
03/07/89
03/07/89
12
11
14
19
9
9
9
Friends Provident Stewardship Inc
UK Income
01/01/88
12
Aberdeen Prolific Ethical
CIS Environ
City Financial Acorn Ethical
Clerical Med Evergreen
Framlington Health
Jupiter Ecology
NPI Global Care
International Growth
01/01/93
01/07/90
02/01/89
02/07/90
01/07/87
01/07/88
01/01/92
Total
2
7
10
7
13
11
4
149
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
- 30 -
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
are investing principally in particular sectors (Health and Environmental
- 31 -
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.
- 32 -
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
- 33 -
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
Number Sector
of 5-year average
periods 5-year
in study returns
Difference Sector Difference
in fund's median
in fund's
average 5-year
average
returns returns
returns
against the
against the
average
median
UK growth sector=
Abbey Ethical
Allchurches Amity
Credit Suisse Fellowship (*)
Friends Provident Stewardship(*)
Scottish Equitable Ethical(*)
Sovereign Ethical
12
11
14
19
9
9
9
10.07
10.49
9.05
10.32
10.95
10.95
10.95
-0.44
-1.80
-1.39
0.01
-0.62
-1.58
-0.17
10.10
10.27
9.10
9.87
10.64
10.64
10.64
-0.46
-1.58
-1.43
0.46
-0.32
-1.28
0.14
UK income sector=
12
10.37
-2.22
10.16
-2.01
International growth sector=
CIS Environ(*)
Clerical Medical Evergreen
Framlington Health
Jupiter Ecology
NPI Global Care(*)
2
7
10
7
13
11
4
11.06
12.24
11.34
12.24
10.35
11.14
12.54
-0.41
0.70
-1.87
-6.65
10.82
-1.12
-0.65
10.53
11.34
10.28
11.34
9.88
10.27
11.66
0.11
1.60
-0.81
-5.74
11.28
-0.25
0.22
All ethical funds
All excluding Health & Evergreen
Larger funds (*) excluding Health &
Evergreen
149
129
53
-0.49
-0.89
-0.39
-0.01
-0.43
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.
- 34 -
•
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
Number Average Standard
Sector Percentile
of 5- percentil deviation average of sector
year
e of fund's standard with lower
periods of 5-year
returns deviation
"risk"
in study returns
UK growth sector
Abbey Ethical
Allchurches Amity
Credit Suisse Fellowship(*)
Friends Provident Stewardship(*)
Scottish Equitable Ethical(*)
Sovereign Ethical
12
11
14
19
9
9
9
43%
24%
42%
47%
40%
31%
50%
2.05%
2.51%
8.32%
5.36%
2.91%
4.55%
3.76%
4.05%
3.99%
4.68%
5.80%
4.00%
4.00%
4.00%
1%
10%
97%
56%
24%
75%
54%
UK income sector
12
25%
3.31%
3.33%
59%
International growth sector
Aberdeen Prol Ethical
CIS Environ (*)
Framlington Health
Jupiter Ecology
NPI Global Care (*)
2
7
10
7
13
11
4
52%
64%
37%
1%
97%
44%
50%
0.47%
1.61%
2.79%
2.84%
6.34%
3.55%
0.61%
0.58%
2.89%
3.65%
2.89%
4.81%
3.57%
2.04%
50%
1%
10%
50%
90%
54%
4%
149
129
53
43%
42%
49%
All ethical funds
All excluding Health & Evergreen
Larger funds (*) excluding Health &
Evergreen
42%
38%
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.
- 35 -
•
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".
- 36 -
Table 8: The results for each period covered
5 year
period
ended
No. of
funds
Average percentage
returns compared
with average fund in
each sector
All=
3/7/89
1/1/90
2/7/90
1/1/91
1/7/91
1/1/92
1/7/92
1/1/93
1/7/93
3/1/94
1/7/94
2/1/95
3/7/95
1/1/96
1/7/96
1/1/97
1/7/97
1/1/98
1/7/98
Ex
sector
funds=
Average percentage
returns compared
with median fund in
each sector
Largest 5
funds=
All=
Ex
sector
funds=
Largest 5
funds=
Percentile ranking
(%) compared with
all other funds in
sector
All =
Ex
sector
funds=
Largest 5
funds
1
1
1
1
1
2
3
5
7
8
11
11
13
13
13
14
14
15
15
0.73
0.96
-0.34
-0.54
0.21
-2.77
1.56
2.21
0.81
-0.20
-0.38
0.23
-0.17
-0.02
1.10
-0.64
-2.10
-1.08
-0.62
0.73
0.96
-0.34
-0.54
0.21
-2.77
-3.12
-1.73
-1.27
-2.23
-1.33
-0.89
-0.58
-0.90
0.60
-0.65
-2.55
-1.09
-0.73
0.73
0.96
-0.34
-0.54
0.21
-2.77
-3.12
-3.19
-3.53
-3.06
-1.45
-1.18
0.49
-0.05
2.02
0.59
-1.48
-0.08
0.61
2.00
1.91
0.25
-0.09
0.09
-2.78
0.89
1.85
0.37
-0.12
-0.59
0.15
0.06
0.64
1.78
0.18
-1.57
-0.46
-0.38
2.00
1.91
0.25
-0.09
0.09
-2.78
-4.19
-2.38
-1.82
-2.26
-1.61
-1.06
-0.41
-0.31
1.27
0.10
-2.06
-0.48
-0.51
2.00
1.91
0.25
-0.09
0.09
-1.85
-2.80
-2.73
-2.95
-2.42
-1.50
-1.24
0.52
0.45
2.18
1.17
-0.79
0.47
0.69
68%
69%
53%
50%
51%
31%
50%
45%
46%
38%
39%
45%
45%
45%
60%
46%
24%
42%
46%
68%
69%
53%
50%
51%
31%
25%
31%
37%
29%
33%
39%
44%
44%
62%
47%
20%
42%
46%
68%
69%
53%
50%
51%
31%
25%
23%
21%
24%
32%
35%
53%
55%
76%
62%
30%
53%
58%
Average of
all periods
-0.06
-0.96
-0.80
0.22
-0.75
-0.46
47%
43%
46%
Table 8 notes:
•
The sector funds referred to (and excluded from the second column of figures in each case) are the
Framlington Health Fund and the Clerical Medical Evergreen Fund.
•
The largest five funds are those referred to on the previous table.
The overall impression of this table is similar to the previous results for individual
funds, with overall returns averaging 0.75% less for the thirteen funds excluding the
sector ones. These results are slightly less favourable than those based on the
average for each fund given in the previous tables (and the effect of excluding the
sector funds is more marked), because they place greater emphasis on 5-year
periods ending from 1992 to 1994. These are the patch of weakest performance in
this study.
Interestingly, the percentile rankings are less affected: the average 5-year period
performance being better than 43% of the other funds in the same sector over the
same period. This is partly helped by some strong performance from the Stewardship
Fund in the earlier periods when it is the only fund contributing to the figures.
- 37 -
The full details of the percentile performances are provided in Table 9 to give an
example of the detail on the performance of each fund over each time period.
Table 9: The percentile performance of each fund against all other funds in the same
sector at the same time
Time Period:
From
To
UK growth sector
Abbey Ethical
Allchurches Amity
Credit Suisse
Fellowship(*)
Friends Provident
Stewardship(*)
Scottish Equitable
Ethical(*)
Sovereign Ethical
TSB Environmental
Investor
Jul-84 Jan-85
Jul-85 Jan-86
Jul-86 Jan-87
Jul-87 Jan-88
Jul-88
Jan-89
Jul-89 Jan-90
Jul-90 Jan-91
Jul-91 Jan-92
Jul-92 Jan-93
Jul-93
Jan-94
73%
62%
45%
12%
68%
69%
53%
50%
51%
6%
6%
14%
71%
67%
8%
56%
44%
33%
34%
36%
5%
4%
4%
UK income sector
Friends Provident
Stewardship Inc
International growth
sector
AberdeenProl Ethical
CIS Environ(*)
City Fincl Acorn Ethical
Clerical Medical
Evergreen
Framlington Health
Jupiter Ecology
NPI Global Care(*)
Averages by time
period
All ethical funds
All funds ex Health &
Evergreen
Largest 5 funds (*) ex
Health & Evergreen
16%
100%
100%
100%
35%
100%
26%
68%
68%
69%
69%
53%
53%
50%
50%
51%
51%
31%
31%
50%
25%
45%
31%
46%
37%
38%
29%
68%
69%
53%
50%
51%
31%
25%
23%
21%
24%
- 38 -
Table 9 (continued)
Time Period:
From
To
Jul-89 Jan-90
Jul-90 Jan-91
Jul-91 Jan-92
Jul-92 Jan-93
Jul-93 Average
Jul-94 Jan-95
Jul-95 Jan-96
Jul-96 Jan-97
Jul-97 Jan-98
Jul-98
of all
periods
UK growth sector
Abbey Ethical
Allchurches Amity
Credit Suisse
Fellowship(*)
Friends Provident
Stewardship(*)
Scottish Equitable
Ethical(*)
Sovereign Ethical
TSB Environmental
Investor
UK income sector=
Friends Provident
Stewardship Inc
International growth
sector
AberdeenProl Ethical
CIS Environ(*)
City Fincl Acorn Ethical
Clerical Medical
Evergreen
Framlington Health
Jupiter Ecology
NPI Global Care(*)
Averages by time
period
All ethical funds
Evergreen
Health & Evergreen
66%
31%
8%
69%
41%
13%
49%
27%
19%
56%
12%
64%
42%
10%
92%
12%
12%
89%
4%
8%
92%
5%
9%
78%
6%
6%
87%
43%
24%
42%
39%
40%
49%
55%
75%
58%
27%
38%
20%
47%
49%
53%
59%
33%
58%
49%
19%
25%
20%
40%
23%
49%
16%
62%
15%
37%
42%
46%
68%
42%
29%
40%
16%
36%
36%
53%
33%
85%
31%
50%
=
25%
=
60%
=
63%
=
89%
=
33%
=
1%
43%
42%
85%
36%
0%
68%
24%
0%
77%
58%
0%
64%
62%
3%
7%
0%
0%
50%
61%
57%
2%
54%
84%
33%
3%
52%
64%
37%
1%
98%
15%
99%
34%
99%
47%
99%
26%
99%
66%
88%
61%
50%
95%
27%
7%
86%
63%
63%
93%
84%
81%
97%
44%
50%
39%
33%
45%
39%
45%
44%
45%
44%
60%
62%
46%
47%
24%
20%
42%
42%
46%
46%
47%
43%
32%
35%
53%
55%
76%
62%
30%
53%
58%
46%
=
9%
=
4%
=
0%
Averages for each
fund across all time
periods
All ethical funds
Evergreen
Health & Evergreen
4.7
=
25%
43%
42%
49%
Supplementary research into risk as measured by
volatility of monthly returns
Some further exploration of the rather surprising results in relation to risk was felt
necessary. Although the volatility in 5-year returns is one possible measure, it is more
usual to look at volatility over shorter periods, typically monthly returns. Money
- 39 -
Management have been providing tables of the volatility of monthly returns over the
last 36 monthly periods since 1996 (36 months periods going back to 1993), which
can be annualised by multiplying the monthly figures by the square root of 12.
While this covers less than half the period of the study, the results set out below show
that in all these periods and all three sectors (excluding the sector funds), the ethical
investment funds had lower annualised volatility than the average for the sector in
which they are placed.
Table 10: Annualised standard deviation of monthly returns for the 36 month period
ending as specified
Fund name (Jul 98)
Abbey Ethical
Allchurches Amity
Credit Suisse Fellowship
Scottish Equitable Ethical
Sovereign Ethical
Average UK growth ethical=
UK Growth sector=
4.8
Annualised figures for 36 months ended on
Average 1-Jul-98 1-Jan-98 1-Jul-97 1-Jan-97 1-Jul-96
10.0
9.4
8.7
9.0
11.4
11.4
8.6
7.3
7.3
8.0
10.0
10.4
10.9
10.0
9.0
10.0
12.8
12.5
10.1
9.7
9.4
10.0
10.4
11.1
10.7
10.0
9.0
10.4
11.4
12.8
12.3
11.4
11.1
11.8
13.9
13.2
10.1
10.0
8.7
8.7
11.8
11.4
10.4=
10.9=
9.7=
10.4=
9.0=
9.7=
9.7=
9.7=
11.7=
12.5=
11.8=
12.5=
Inc
UK Equity Income sector=
9.0
8.7
8.3
8.3
10.0
9.7
10.1=
9.0=
9.0=
8.7=
11.8=
12.1=
CIS Environ
Framlington Health
Jupiter Ecology
NPI Global Care
10.3
8.7
12.5
11.8
23.5
10.9
10.7
9.7
9.0
12.8
12.8
24.6
11.8
10.0
8.7
7.6
11.4
12.5
24.6
10.0
9.7
9.4
7.3
11.4
11.1
24.9
10.7
9.7
11.8
9.7
14.2
11.4
24.2
11.1
12.5
12.1
10.0
n/a
11.1
19.1
11.1
11.8
Average international
growth ethical=
Average international
growth ethical (ex
Evergreen & Health)=
International Equity Growth
12.6=
13.0=
12.1=
12.1=
13.6=
12.5=
10.6=
10.7=
9.5=
9.7=
11.8=
11.3=
12.0=
12.5=
12.1=
11.1=
12.1=
12.1
Conclusions and implications
- 40 -
These conclusions are based largely on the aggregate data, excluding the two ethical
"sector" funds.
(1)
On average, ethical funds have lower total risk than funds without ethical
criteria.
This is a rather remarkable conclusion that runs counter to conventional wisdom
outside the ethical investment world, but may also have implications for thinking
within the industry.
It is often supposed by financial commentators that because ethical investment can
involve avoiding at least some large companies, it must be a more risky undertaking.
This would appear not to be the case at the level of a portfolio of such stocks.
It should perhaps be explained that the financial community speak of risk in relation to
equities in at least two senses:
a) Tracking error
Tracking error is normally the extent of deviation from some recognised stock market
index in the market in question, such as the FTSE All-Share Index. A tracking error of
3%, for example, means that two years out of three you could expect your portfolio to
perform within 3% (up or down) of the performance of the FTSE All-Share Index. A
significant theoretical reason for interest in this measure is that the best balance of
risk and return is supposed to be obtained by matching the Index weightings of
stocks. Any deviation from that balance involves a less than “optimal” balance of risk
and return (although the theoretical costs of such deviations are often very small, as
shown in other chapters of this report).
A more practical reason for concern about it is that if a fund manager is having their
performance measured against a particular index, then the tracking error is an
indication of the likely under-performance from time to time. And under-performance
could result in the client taking their business elsewhere if they forget (or have not yet
experienced) the matching out-performance that might be expected at other times.
b) Total risk
- 41 -
Total risk (sometimes separated into systematic and specific) is the volatility of the
investments (their average or expected fluctuations in value) irrespective of any such
market indices.
Ethical investment does clearly involve tracking error. If you do not invest in all the
shares in an index, you can expect to perform differently. But the intriguing thing
about this study is that it suggests that the approaches followed by these funds may
actually reduce total risk.
The assumption within the industry in recent times has been that institutional clients
will need ethical investment opportunities with a lower tracking error to attract pension
funds that feel nervous about taking risks with pension money. Indeed some within
the pension fund world have gone as far as to suggest that ethical funds should be
classed alongside emerging market funds in terms of their risk profile.
If in fact total risk can be reduced rather than increased, then all this needs to be revisited. It may be that pension funds need more careful advice from their actuaries
and risk measurement experts about the balance of risk and return, and about
appropriate performance benchmarks, rather than looking for ethical investment
opportunities with minimum tracking error.
(2)
On average, ethical funds have lower returns, although there are a number of
examples of out-performance, in some cases sustained over long periods.
The implications here are that it is possible to perform well within an ethical
framework, but that it would be unwise for advocates of ethical investment to argue
that out-performance is inevitable or necessarily to be expected.
To an extent the average under-performance could simply be the other side of the
average reduced risk, and this possibility is explored further below.
It is also possible that such an effect could be attributable partly to higher charges -at
least some of the firms offering such funds make a higher charge for their ethical
funds than for those funds without ethical criteria. This question has not been
explored in any more detail in the present study, but is of potential longer term
significance, particularly as some of the recent entrants to the retail market-place
have been adopting lower charges as part of their approach.
- 42 -
(3)
The overall performance figures mask significant variations between funds,
and over different periods that present a more complex picture.
Detailed conclusions at the level of individual funds (see Table 9) would include the
following:
(a)
One cannot explain the result solely in terms of the ethical criteria used. So,
for example, the Stewardship and the Fellowship criteria look similar, but the most
recent performance of Credit Suisse Fellowship has been at the top of the sample,
and the most recent performance of Stewardship has been at the bottom.
(b)
Neither is the most recent 5-year performance a particularly good guide to the
performance over the whole life of each product. So, for example, if you look at the
latest 5-year period the best performers are Credit Suisse Fellowship, TSB
Environmental Investor, CIS Environ, Framlington Health, Jupiter Ecology and NPI
Global Care. However, if you look at performance over the whole life of each fund
(see Table 6), Stewardship, the longest established fund, performs better than all but
two of these, and two of them perform worse than the median fund in their sector.
Credit Suisse is a good example of a fund that started with consistently poor
performance, but had achieved consistently good performance towards the end of the
period covered. In other words, even 5-year performance can change significantly
over time, and one does need to look at the whole life of each fund to get a complete
picture.
Results cannot simply be explained as a split between "green" and "wider ethical"
approaches, since there are examples of both good and bad performance in either
group, particularly when you look back over the whole period of the study.
(4)
Balancing the merits of risk and return would be something each investor
might want to do in a different way, but the balance offered by these funds
does not look materially different from that offered by funds without ethical
criteria.
There are two pieces of evidence for this assertion in the figures presented. The first
is the percentile figures in Table 7. The thirteen ethical investment funds had a higher
return than 42% of the other funds in their respective sectors, but only 38% of other
- 43 -
funds had lower risk. Their comparative out-performance in terms of reduced risk was
greater than their comparative under-performance in terms of reduced performance.
The second way to approach the same point is to say that there seems to be (on
average) a little less than 0.5% under-performance on returns, which is about 5% of
the roughly 10% return per year that unit trusts have returned over the period studied.
Table 10, however, suggests that volatility (also against an average of about 10%) is
reduced by perhaps as much as 1%, or 10% of the volatility of equivalent funds.
Whether this represents a reasonable balance depends upon the individual investor’s
preference and what "risk free" rates of return would be available to them, but it
seems reasonable to assert that the balance of risk and return is not materially
different from that of conventional funds.
4.9
The need for further research
The combination of marginal affects on performance overall, and on average, with
significant differences within the sample, and over different time periods suggests a
need for further research into the causes of the different performance of these funds,
and how that relates to their ethical investment approach.
Relevant questions would include whether the strategy of particular funds has
changed significantly at particular points in their life, and developing an understanding
of why that was, and whether it helped or not. And if one can understand why some
investment approaches have combined well with particular ethical policies one could
also move towards an understanding of how sustainable that advantage might be
expected to be, or what factors would help or hinder its continued success.
Clearly if there are general lessons to be learnt about what investment approaches
work best with ethical investment then there is the possibility of improving financial
performance within an ethical framework (or some ethical frameworks) over time. If
such approaches can be identified, then this will make ethical investment in general
potentially more attractive to more investors over time.
- 44 -
5
Other studies of financial performance
5.1
Overview
Attempts to examine the relationship between ethical investing and financial return
now go back 20 years when studies were first done on the impact of excluding stocks
which had subsidiary operations in South Africa from the Universe. This research can
be broken down into the following three areas:
At the portfolio level
•
Research into the performance of real portfolios where stock selection was
subject to ethical as well as financial criteria
•
Research into the performance of theoretical portfolios constructed using ethical
criteria
At the company level
•
Research into the individual performance of companies which are identified by
particular ethical criteria
The research at the portfolio level generally involves measuring the risk and return
compared with a benchmark such as the FTSE All-Share Index. The research at the
company level involves measuring return on assets, sales and equity, or share price.
For each study the research is briefly outlined together with the main findings.
5.2
Research into actual portfolio performance
5.2.1
Introduction
The research reported here looks at the experience of some of the ethical investment
funds in the UK.
Research by Luther et al in 1992 and 1996 looked at the nature of UK ethical trusts
and found that they had a strong smaller company bias and were less internationally
diversified than other UK trusts. These were the main drivers of performance of UK
ethical trusts. Net of the smaller companies effect Luther et al found little evidence for
underperformance. The WM Company looked at the performance of ethically
- 45 -
constrained charity funds over a four-year period and found that the policy of avoiding
certain ethically unacceptable stocks or sectors from portfolios had little impact.
5.2.2
The Investment Performance of UK ‘Ethical’ Trusts - Luther, Matatko,
Corner (1992)
Luther et al looked at risk and return for 15 ethical unit trusts. They found that in risk
terms, most UK ethical trusts offer a level of volatility closer to that of an
internationally diversified index than to a domestic benchmark. In performance terms,
while there appeared to be little evidence of underperformance there is some weak
evidence showing possible above index performance. Luther et al also looked at the
size distribution of the trust portfolios and found that ethical trusts were skewed
towards smaller companies. They found that ethical investing is correlated with at
least 3 factors which may have an impact on realised returns: low market
capitalisation, international diversification and low dividend yield.
5.2.3
Ethical Unit Trust Financial Performance: Small Company Effects &
Fund Size Effects - Gregory, Matatko, Luther (1996)
Gregory et al carried out a time series matched pairs analysis of unit trust
performance together with cross-sectional analysis of unit trust performance, using
the period Jan 1986 to Dec 1994. The study shows that ethical unit trusts have
significantly greater exposure than general unit trusts to the ‘small firms effect’, and
that net of this there is no significant evidence of over or under performance by ethical
trusts using an adjusted Jensen12 measure. However, Gregory et al found that if a
conventional Jensen measure was used ethical trusts appeared to exhibit some
significant under-performance.
5.2.4
Is there a Cost to Ethical Investing - WM Company (1997)
WM compared the performance of an Ethical Universe which comprised 20 charity
funds with a value of £822m at the end of 1995 with the Unconstrained Universe
which comprised 140 charity funds with a market value of £4.5bn over the period
1992-5. The ethical restrictions placed on some of the constrained charity funds
related to alcohol, armaments, and gambling, and all had tobacco exclusions.
12
Jensen measure J p = R p – R bm where R p is the log return on the unit trust and R bm is the log return on the
single factor benchmark. The adjusted Jensen measure adjusts the measure for smaller companies.
- 46 -
Little difference was found in the UK equity returns on an annual basis and over the
four-year period. Larger annual differences were apparent in the annual returns on
overseas equities, but over the four years, the annualised difference was negligible.
At the total return level, the Unconstrained Universe outperformed the Ethical
Universe by 0.2% per annum, due to policy differences. WM found that constraints
other than the requirement to exclude sectors/stocks on ethical grounds (such as
income constraints) have a more meaningful impact on relative performance.
In 1996 WM began maintaining the FTSE-A All-Share Index Ethical Restraints Index,
a capital only index. This comprises the FTSE-A All-Share with about 50 stocks
excluded mainly for arms, alcohol, gambling or tobacco (all at the 5% of turnover
level), and a few stocks excluded for environmental reasons. At the time of the report
the Index only had performance figures for the ten-month period preceding and had
outperformed the All-Share (Capital) Index. WM have also calculated an ex-Vices
Index since January 1992. Compared with the All-Share Index, the ex-Vices Index
(excluding the alcohol, gambling and tobacco sectors) outperformed over all
annualised rolling 3 year returns of the monthly data (by on average about 1% per
annum) but it was also consistently more volatile (by around 0.2% per annum). WM
said, if sustained, this was a good return to risk trade-off.
WM also analysed the performance of the FP Stewardship Managed Pension Fund
and found evidence that a significantly restricted universe of ethical investments can
provide consistent competitive performance and that there appeared to be some
added value over and above the smaller company effect.
5.3
Research into theoretical portfolio performance
5.3.1
Introduction
As a result of the South African divestment movement, the earliest research into
ethical portfolio performance related to portfolios constrained by South Africa
exclusions. Rudd found a very small degree of underperformance resulting when
avoiding US stocks operating in South Africa. In the UK, Woodall looked at 40 sets of
ethical criteria and found in general a small loss resulted from applying ethical criteria.
Rudd, Wagner et al and Woodall found the restrictions would increase investment
risk.
- 47 -
Joint research of EIRIS and BARRA, an investment consulting firm, constructed eight
indices drawn from the FTA, each of which represented the use of a different set of
ethical criteria. Four of these indices underperformed and four outperformed the FTA.
Kahn et al found slight underperformance due to tobacco divestiture whereas
Guerard found some screens led to higher excess returns and Antonio et al found
that bond portfolio performance for a screened index was comparable in terms of risk
and return.
5.3.2
Divestment of South African equities: How risky? – Rudd (1979)
This was one of the first studies to look at the implications of operating an ethical
investment policy in the context of modern portfolio theory. Rudd looked at the
avoidance of 177 US S&P companies (42% of the S&P 500 market value) operating
in South Africa. This list of stocks was then optimized to form a portfolio that matched
the S&P 500 as closely as possible. Rudd found that the effect on portfolio risk of
excluding the companies operating in South Africa was not particularly important. He
derived a formula which related the increase in ‘units of volatility’ (square of the
annual standard deviation or tracking error) to expected loss. The general result was
0.0075% for every unit of volatility. He found that while there is some increase in risk,
it should not be prohibitively significant unless a very large number of stocks are
excluded. Rudd calculated that a loss of only 0.03% a year might be expected based
on an increased annual tracking error of 2-3%.
5.3.3
South African Divestment: The Investment Issues - Wagner, Emkin &
Dixon (1984)
Wagner et al examined the effects of divesting from the 152 companies in the S&P
500 with South African links. They replaced each with the largest company available
in the same industry. This universe accounted for less than 62% of the value of the
S&P 500. The returns for these companies were examined over the five-year period
to the first quarter of 1984.
They found that there was a difference of over 7% in the annual rate of return
between the 152 company South Africa free portfolio and the replacement 152
companies. The rates of return were higher for the non-South African linked
companies than for the South African linked ones, a possible smaller company effect.
- 48 -
Wagner et al then looked at the increase in risk using the portfolio’s beta and Rsquared. The beta measures sensitivity to changes in the overall market or volatility.
The R-squared measures the degree of diversification in comparison to the market
benchmark. An actively managed portfolio with a bias towards favoured stocks and
sectors would be less diversified than the market and have an R-squared below the
market. The market, as measured by the S&P 500, has a beta and R-squared of 1.0.
They found that the non-South Africa linked universe was very well diversified with an
R-squared of 0.968 but that it was riskier than the market, having a beta of 1.08. The
overall conclusion of the study was that divestment restrictions may have a
substantial impact on the investment management activities of large portfolios. They
stated “In general, the restrictions will increase investment risk, reduce investment
and diversification opportunities, and increase the costs of research, trading and
administration. And the larger the fund, the greater the impact will be.”
Wagner et al also assessed the implications of this for fund management style. Not all
management styles would be equally affected by restrictions on South African
companies. For example, an “emerging growth” manager would be likely to be less
affected than a “core” manager, but would face higher market risk and less
diversification. However they then concluded it would be possible to compensate for
some of these effects.
5.3.4
The Cost of Imposing an Ethical Constraint on an Investment
Portfolio – Woodall (1986)
Woodall attempted to quantify the cost of imposing an ethical investment policy by
constructing 40 theoretical portfolios which excluded companies offending one or a
group of ethical criteria. Woodall calculated the average market value, the portfolio
beta, the total risk, the systematic risk, return, marketability of shares, gross yield and
industry weightings, as well as two further measures of loss, Markowitz efficiency and
increased residual risk. The results showed that in general a small loss (between 4
and 8 basis points) resulted from applying ethical criteria. The most likely cost was in
the form of increased industry specific risk, a bias towards smaller companies, and a
corresponding reduction in the marketability of shares and gross yield.
- 49 -
5.3.5
The Financial Performance of Ethical Investments - EIRIS/BARRA
(1989)
This research involved constructing eight indices by excluding all companies from the
FTA All-Share Index that offended a particular criterion or in one case a set of criteria
as below:
• Index 1 – South Africa free (any equity involvement)
• Index 2 – South Africa free (more than 1,000 employees)
• Index 3 – South Africa free (pay more than 100 employees or over 10%
of black African employees below the SLL (5))
• Index 4 – Nuclear weapons free
• Index 5 – Tobacco free
• Index 6 – Nuclear power free
• Index 7 – Financial free
• Index 8 – Combination of restrictions used for portfolios 2, 4 and 5.
The indices were constructed on a market cap basis and the characteristics of these
portfolios compared with the All-Share Index using BARRA’s risk measurement
facilities. The risk-measurement facilities allow you to rank portfolio characteristics to
show how a portfolio compares with the market with respect to certain indicators that
are seen to influence share performance such as size and earnings/price ratios. This
analysis covered the five-year period October 1983 to October 1988.
The betas of the various portfolios ranged from 0.95 to 1.01. In half the cases, being
underexposed to large companies was the best policy in terms of performance, and in
two cases being overexposed to large companies was the worst policy. Size was the
dominant factor in terms of differential performance across all portfolios. The other
four best policies were sector related.
Four of the portfolios had an average monthly performance that was better than the
All-Share Index, while the other four were worse. The five year cumulative return
mirrored this and ranged from 147.4 to 169.2, while the All-Share Index was 161.6.
The yield of the six portfolios was better than the All-Share Index, ranging from 4.08%
to 4.79%, while the All-Share Index was 4.36%. The monthly portfolio tracking errors
ranged from 0.27% to 1.08%.
- 50 -
5.3.6
EIRIS/BARRA (1993 - unpublished)
EIRIS devised a portfolio by screening all the FTA All-Share Index companies against
the criteria used by most of its clients. This left 151 acceptable companies for
investment, representing 9% of the value of the FTA All-Share Index. Investment in
this portfolio in proportion to its market value was simulated for the period from
January 1988 to October 1991. The result of this was an annualised return of 8.1%,
compared with a return of 13.2% for the All-Share Index. But using BARRA’s
optimising system to adjust the size of holdings to make it look more like the All-Share
Index, the result was an annualised return of 14.1%.
5.3.7
The Private Cost of Socially Responsible Investing - Diltz (1995)
Diltz examined common stock portfolios over the period 1 January 1989 to December
1991 in order to determine whether social screening has an impact on portfolio
performance. He looked at excess returns (corrected for market risk) in various ways
to control for seasonal and other effects. He concluded that the consequences of
some 11 different ethical screens and combinations of them were largely neutral. He
found some evidence that certain ethical screens – good environmental performance,
military and nuclear industry avoidance – may in fact enhance portfolio performance
while the market appears to penalise firms that provide family-related benefits such
as parental leave and job sharing.
5.3.8
Environmental and Financial Performance: Are They Related? Cohen, Fenn & Naimon (1995)
This study examined the relationship between environmental and financial
performance using environmental performance data compiled by IRRC and common
measures of firm performance. IRRC looked at compliance data, chemical release
data, chemical spill data, data on hazardous waste cleanup sites, and environmental
litigation proceedings for S&P500 companies and constructed two portfolios, one
containing companies with “high” values of the environmental measure of interest and
another containing “low” values. The portfolios were constructed by matching
companies within industry groups thus controlling for industry specific risk and return
variation. The measures of financial performance included return on assets, return on
equity and total return to shareholders. IRRC then examined whether the “high
pollution” portfolios performed differently to the “low pollution” portfolios over periods
from 1987 to 1991.
- 51 -
Overall the study found no penalty for investing in a “green” portfolio and, in many
cases, low pollution portfolios achieved better returns than high pollution portfolios
and the S&P500 Index. IRRC noted that a finding that good environmental
performance is correlated with high earnings does not necessarily mean that
companies which improve their environmental performance will also improve their
earnings. It is possible that causation is the other way and that companies are good
environmental performers because they are financially strong and can afford to be
“good citizens”.
5.3.9
Just Say No? The Investment Implications of Tobacco Divestiture Kahn, Lekander & Leimkuhler (1997)
Kahn et al looked at the outperformance of tobacco stocks compared with the S&P
500. Over the 10 year period 1987-96 the S&P Ex-Tobacco underperformed by
0.21% in terms of total return and the tracking error (standard deviation of the relative
return) was 0.46. They looked at reducing this risk by replacing tobacco with some of
the highly correlated industries, and found that it was possible to reduce tracking error
to 0.42 from 0.46. The conclusions were that overall “tobacco divestiture doesn’t
stand up as an investment decision. It doesn’t reduce risk in the typical pension fund
context. We should see tobacco divestiture for what it is: a moral decision.”
5.3.10 Additional Evidence on the Cost of Being Socially Responsible in
Investing – Guerard (1997)
Using regression analysis Guerard showed that the use of a) environmental, b)
alcohol, tobacco & gambling, c) military and d) nuclear screens produces portfolios
with higher excess returns than those from unscreened portfolios and tobacco-free
portfolios for the period 1987-96 period. The only social screen that consistently costs
the investor returns is the military screen for the 1992-97 period. Guerard concluded
though that there were no statistically significant differences between the average
returns of a socially screened and an unscreened universe during the period 1987-96.
5.3.11 Expanding Socially Screened Portfolios: An Attribution Analysis of
Bond Performance - Antonio, Johnsen & Hutton (1997)
Antonio et al looked at whether a bond index, similar to existing US socially screened
indices, could be developed and perform as well as the unscreened indices. They
used the Lehman Brothers Corporate Bond Index (LCB) as the benchmark and KLD’s
Domini 400 as the universe of socially responsible companies to construct a bond
index and looked at the total monthly returns for the period May 1990 to March 1996.
- 52 -
The average monthly return for the SRI portfolio was 0.89% with a standard deviation
of 1.44%. In comparison the LCB index returns average 0.84% with a monthly
standard deviation of 1.45%. The average outperformance of the SRI portfolio was
shown by the average active return of 0.04%. The standard deviation of the monthly
return differential (tracking error) was 0.14% (0.485% on an annualised basis).
Overall they found that a portfolio of bonds comprising issues from firms represented
in the Domini 400 performs comparably in terms of risk-return to the Lehman Brothers
Corporate Bond Index and that these indices are identical in their exposures to
changes in term structure.
5.4
Research into impact of ethical behaviour by
companies
5.4.1
Introduction
Evidence appears to be building for a link between eco- and financial performance.
The Alliance for Environmental Innovation, an organisation supporting eco-efficiency
partnerships with business, reviewed over 70 research studies and found that none of
them found a negative correlation between above average environmental
performance and financial performance13. But these studies are sometimes criticised
for a lack of objectivity and rigour. Even accepting that a link exists between
environmental performance and financial performance, this does not prove that the
former causes the latter. Some sceptics point out that it could be the other way round
with superior financial performance allowing more resources for environmental
management.
Below we outline a number of studies researching the impact of ethical behaviour by
companies.
5.4.2
Does it Pay to be Green? An Empirical Examination of the
Relationship between Emission Reduction and Firm Performance Hart & Ahuja (1996)
Hart & Ahuja tested five hypotheses relating to emissions reduction and return on
assets, return on sales, and return on equity in a four-year period using multiple
regression analysis. The results suggest that it does pay to be green. Efforts to
13
Tomorrow magazine, September/October 1998
- 53 -
reduce emissions through pollution prevention appear to drop to the “bottom line”
within one to two years after initiation. Hart & Ahuja found that operating performance
is significantly benefited in the following year, whereas it takes about two years before
financial performance is affected. The biggest bottom line benefits accrued to the high
polluters where there are plenty of low-cost improvements to be made. Hart & Ahuja
concluded further work was needed to test the causality – whether lower emissions
lead to enhanced profitability or if more profitable companies tend to invest in
pollution prevention and emissions reduction activities.
5.4.3
Financial Returns of Public ESOP Companies: Investor Effects vs.
Manager Effects - Conte, Blasi, Kruse & Jampani (1996)
This study examined financial data for 1,743 Employee Share Ownership Plan
(ESOP) sponsoring companies and 7,297 non-ESOP companies for each year from
1981 to 1993. They concluded that the existence of an ESOP was correlated with
outperformance (risk adjusted), but that the adoption of an ESOP during the period
they studied was linked to underperformance.
5.4.4
The Impact of Environmental Management on Firm Performance Klassen & McLaughlin (1996)
Klassen & McLaughlin examined the effects of positive and negative environmental
“events” and announcements of various “unethical” activities using event study
methodology. They searched a newswire service for key words to identify events. The
sample period for positive events was 1985 to 1991 and the sample period for
environmental crises was limited to 1989 to 1990 because of the large number of
duplicate events. They removed observations where there were other financial or
management events that might affect the results.
They found support for the linkage between environmental management and firm
financial performance. Significant positive abnormal stock returns were documented
following positive environmental events. The marketplace rewarded companies that
received awards for investing in areas such as new products and processes that
minimised their adverse environmental impact, improved their environmental safety
systems, and developed strong management programs. They found that an
environmental award in the US typically boosted share price by 0.82% and raised
market value by an average of $80.5m. Oil spills and other environmental disasters
- 54 -
lost firms 1.5% of share price and an average of $390m in market value. They
concluded that these losses significantly exceeded the direct costs involved.
5.4.5
A Quantitative Analysis of the Impact of Unethical Behaviour by
Publicly Traded Corporations - Gunthorpe (1997)
This study examined whether or not publicly traded corporations are penalised in the
financial markets for their unethical actions. It used event study methodology to
investigate the stock price reaction to an announcement that a firm is under
investigation or is being sued for unethical business practices. Gunthorpe looked at
the period between 1988 and 1992 for announcements in the Wall Street Journal that
a firm or senior management were either under investigation, the subject of a law suit
or that an indictment had been issued against them for illegal business practices. The
event study of 69 corporations found that public announcements in the US concerning
a range of ethical misdemeanours such as fraud, price fixing, bribery and patent
infringement
typically
impose
a
statistically
significant
one-day
penalty
of
approximately 1.3%, and as much as a 2.3% penalty over a seven day period in
terms of share price.
5.4.6
Finding the Link Between Stakeholder Relations & Quality of
Management - Waddock & Graves (1997)
Waddock & Graves compared the relationship of management quality to treatment of
specific stakeholders using regression analysis. They used Fortune’s annual survey
of executives, directors and analysts which generates reputational ratings and a
quality of management indicator for the Fortune 500 largest firms. They used data
from KLD to measure stakeholder relationships other than ownership. Waddock &
Graves found that the relationship between the quality of management and the
treatment of owners (measured by financial performance), employee relations and
product (the surrogate for customer relations) is strongly and consistently positive.
There was less evidence for a positive relationship for community relations. The data
indicated that key components of quality of management may be interlinked and that
they relate not only to financial performance but also to the ways in which the
business treats key constituents, mainly employees and customers.
- 55 -
5.4.7
Does Improving a Firm’s Environmental Management System and
Environmental Performance Result in a Higher Stock Price? Feldman, Soyka, Ameer (1997)
Feldman et al produced a model linking the evaluation of corporate environmental
performance to the market value of publicly traded corporations. The model had 5
components:
corporate
environmental
performance,
environmental
signalling,
management
firm
risk
and
systems,
firm
environmental
value
(including
environmental). The model was tested over the period 1980-94. Feldman et al found
that adopting a more environmentally proactive posture has, in addition to any direct
environmental and cost reduction benefits, a significant and favourable impact on the
firm’s perceived riskiness to investors, and its cost of equity capital and value in the
marketplace. They concluded that the results strongly suggest that firms which
improve both their environmental management systems and performance can
increase their stock price by as much as 5%.
5.4.8
A Resource-Based Perspective on Corporate Environmental
Performance and Profitability - Russo & Fouts (1997)
Russo and Fouts tested the hypothesis that high levels of environmental performance
will be associated with enhanced profitability. They did this by examining the
profitability of 243 companies assigned environmental ratings by the Franklin
Research and Development Corporation over the two-year period 1991-2. The
environmental ratings were based on compliance records, expenditure and other
environmental initiatives. Regression analysis was used to examine the
relationship between return on assets and environmental ratings and used a number
of control variables including firm size, firm growth rate, advertising intensity, capital
intensity, industry concentration and industry growth rate. Russo and Fouts concluded
that it did pay to be green and that this relationship strengthens with industry growth,
although the environmental rating did not account for more than a modest level of
variation in firm performance.
5.4.9
The Link between Company Environmental & Financial Performance David Edwards (1998)
Edwards compared the financial results of 50 “green” companies which were
assessed by Jupiter Asset Management as being the best in their sectors
environmentally with those of “non-green” companies in the same sectors over the
five year period 1992-6. These green companies were identified by the Jupiter
Environmental Research Unit environmental assessment process used for the Jupiter
- 56 -
Ecology Fund and were from 8 different industry sectors. The financial indicators
used were return on capital employed and return on equity. First the financial
performance of each green company was compared to the average financial
performance of similar non-green companies in the same sector. Secondly the
financial performance of each green company was compared to that for the best
financial performer from the non-green sample.
Edwards concluded that there was a positive link and that over two-thirds of green
companies perform better than their non-green equivalents. Even at the second stage
of the study Edwards found that the green companies performed as well as the nongreen companies when the best financial performers were selected from the nongreen sample, though the results were not as conclusive.
5.4.10 Pensions and the Environment - Nottinghamshire County Council
(1998)
Nottinghamshire County Council commissioned a research study on the issue of
environmental investment and its impact on the returns for a public sector pension
fund in the short, medium and long term. This study concentrated on environmental
factors rather than other ethical criteria as the link between these and financial
performance was believed to be more complex. They looked at different scenarios for
growth around the world and the main channels for environmental protection, such as
subsidisation, regulation, disclosure etc. The significance of these was then assessed
according to the type of environmental problem (air pollution, toxic waste etc.) and the
specific country or region concerned. Problem sectors and regions contributing most
to environmental degradation were assessed. Nottinghamshire then used a system of
weighting to get a direct economic impact rating for each sector and region for a
current environmental severity assessment, and produced a sustainability rating for a
forward looking assessment.
These environmental ratings were tested for evidence of a negative correlation with
average total returns for companies operating in individual sectors using regression
analysis. The results obtained showed a negative correlation between the
environmental assessment scores and average total returns for the UK and Europe
for both a 10 and 20 year period, and were statistically significant. For the US there
was weaker evidence for this negative correlation. In Japan there was positive
correlation and in South East Asia there was little evidence for correlation.
- 57 -
These regressions were run again, leaving out individual sectors and environmental
issues one at a time and this policy tool was found to be comparatively stable, with
the exceptions of mining and the media in the US and mining in Japan.
The study found that the improvement that can be made from the average market
position as a result of environmental assessment is probably of the order of ½% per
annum.
Nottinghamshire then considered how to implement this policy tool as a long term
investment policy. They set up a pilot study for the UK market to flag up key sectors
where environmental issues were of concern so that the fund managers would then
conduct background research to establish whether companies in those sectors faced
serious environmental issues that could threaten financial returns in the short,
medium or long term and whether they were addressing those issues. They used an
investment questionnaire to do this. In overall terms the pilot study showed some
value from the process but problems arose where short term prospects were good but
medium or long term prospects were not good and what to do in these cases. The
fund managers had difficulty interpreting and processing the information as they were
not environmental specialists and the task was felt to be too onerous. How the policy
tool can be fully applied to Nottinghamshire’s Pension Fund is still to be seen.
5.4.11 Corporate Performance is Closely Linked to a Strong Ethical
Commitment - Verschoor (1998)
Verschoor analysed a section of the annual reports of 500 of the largest US public
companies for this study. Verschoor looked for evidence of a public declaration of a
commitment to a code of ethical conduct. He found that just under 27% of companies
make a public representation that an expectation of ethical behaviour or conformity to
a code of ethics or corporate code of conduct is an aspect of their internal control
system. Verschoor found that 14% of the 500 had a more extensive or explicit
commitment to ethical accountability. Verschoor then compared the performance of
companies that made an ethical commitment with those that did not using the Stern
Stewart Performance 1000 report of Market Value Added (MVA) as published in
Fortune Magazine. Verschoor concluded that companies publicly committing to follow
an ethics code as an internal control strategy achieved significantly higher
performance measured in both financial and non-financial terms.
- 58 -
Verschoor recognised that the strong linkage of these two factors does not
necessarily indicate a causal relationship. He then studied Ethics Officer Association
membership (as a measure of companies which have more effective ethics programs)
and found that this did not appear to be a determinant of superior corporate
performance. Verschoor concluded from this that the most plausible cause of superior
performance is that an ethical tone has been set at the top of certain organisations
that permeates at all levels, and the nature of the values that management and
directors have infused into an organisation over time. He concluded that legalistic
codes of conduct designed only to protect an organisation from conflicts of interest or
rogue managerial behaviours are unlikely to motivate loyal employee behaviour and
do not result in long term retention of favourable relationships with suppliers,
customers and other stakeholders.
- 59 -
6
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Divestiture, Journal of Investing Winter 1997
Klassen & McLaughlin, The Impact of Environmental Management on Firm
Performance, Management Science Vol.42. No.8, August 1996
Luther, Matatko, Corner, The Investment Performance of UK ‘Ethical’ Trusts,
Accounting, Auditing and Accountability Journal Vol. 5 No. 4 1992
Gregory, Matatko, Luther, Ethical Unit Trust Financial Performance: Small Company
Effects & Fund Size Effects, Department of Accounting & Finance, University of
Glasgow, Working Paper 96/6
- 60 -
Nottinghamshire County Council and Public and Corporate Economic Consultants
(PACEC) Pensions and the Environment, 1998
Rudd, Divestment of South African equities: How risky?, The Journal of Portfolio
Management, Spring 1979
Russo & Fouts, A Resource-Based Perspective on Corporate Environmental
Performance and Profitability, Academy of Management Journal, 1997
Verschoor (1998), Corporate Performance is Closely Linked to a Strong Ethical
Commitment
WM Company (1997), Is there a Cost to Ethical Investing?
Waddock & Graves, Finding the Link Between Stakeholder Relations & Quality of
Management, Journal of Investing, Winter 1997
Wagner, Emkin & Dixon, South African Divestment: The Investment Issues, Financial
Analysts Journal November/December 1984
Webley, Lewis & Mackenzie (1998), Loyalty in Ethical Investment: An Experimental
Approach, School of Psychology, University of Exeter and Centre for Economic
Psychology, University of Bath
Woodall (1986), The Cost of Imposing an Ethical Constraint on an Investment
Portfolio
- 61 -
7
Glossary of terms
Beta
A measure of market risk. Beta (also referred to as systematic risk) is a measure of
the relative volatility. The Beta is the amount the first fund moves when another
moves by one unit. If one fund always goes up and down by 1.5 times the
performance of the index, its beta will be 1.5. This implies that if the return of the
index is positive, then 1.5 times this positive return can be expected of the fund. If the
index goes up (or down) 10% the fund goes up (or down) by 15%. Beta represents
the volatility of the first investment versus the second. It is only an estimate and to be
accurate there has to be a perfect correlation between the two investments. Beta
measures the tendency of your portfolio to participate in general market moods.
Portfolios with betas of around 0.5 or less would be described as defensive positions
and those with a beta of two or more would generally be described as aggressive or
risky.
One way of calculating beta is shown below:
Beta = (the return volatility of the portfolio) x (correlation values of market and
portfolio) / (the return volatility of the market)
Correlation
Correlation shows the strength of a linear relationship between two funds. A perfect
correlation is when the two funds behave in exactly the same manner. A perfect
positive correlation is represented by +1, perfect negative correlation by –1, and no
correlation by 0. A perfect negative correlation suggests that for every 1% movement
by the index we would expect to see –1% movement return on the fund and vice
versa. This is an important factor when using modern portfolio theory.
R-squared
The R2 indicates the level of movement that can be ascribed or determined by a
movement of an index. When the R2 equals 1 there is a perfect correlation – 100% of
the movement in a fund can be determined by the movement in an index. When the
R2 equals zero there is no correlation between the investments. An R2 between 0.7
and 0.99 suggests that between 70 to 99% of the movement in a fund could be
explained by the movement in the index. Below 0.3, there is effectively no influence.
- 62 -
Tracking error
A measure of the volatility relative to the market. It is a quantification of how different
the investments are to the accepted benchmark and directly reflects a portfolio
manager’s approach.
To assess a portfolio’s financial performance, investors look at the performance of
‘the market’ or an appropriate benchmark. The most widely used benchmarks are
indices such as the FTSE All-Share Index, indicators of the movement up and down
of the stock market.
In the UK ethical funds generally benchmark their performance against the FTSE AllShare Index or a peer group of funds, which could be a selection of other ethical
funds in the same unit trust sector. However most ethical funds have a different
ethical policy with different ethical criteria.
Aggressive portfolio managers whose aim is to significantly outperform the market will
go for a large tracking error. They will use different investments to the market portfolio
and take on more active risk in an attempt to create larger excess returns. Less
aggressive portfolio managers will stick as closely as possible to the benchmark and
keep their active risk to a minimum.
It is not uncommon for the most aggressive managers to show a tracking error in
excess of 10%, while conservative portfolio managers will usually opt for a tracking
error of 2% or less. It is usually the tracking error which is used to sell a particular
fund to an investor i.e. ‘best performing emerging market fund for the last 3 years’
shows that the fund manager must have accepted a larger tracking error from the
accepted emerging market index.
A fund manager’s style is usually shown by the construction of a portfolio with a beta
less than or greater than 1 by holding larger quantities of preferred stocks,
overweighting the portfolio in a particular sector or choosing high numbers of stocks
or investments with particular characteristics such as low P/E ratios.
Portfolio type
14
Typical tracking errors14
Understand Financial Risk In a Day, Alex Kiam 1997
- 63 -
Index fund
0.5-1%
Blue chip fund
2-4%
Income fund
4-6%
Growth fund
5-7%
Small companies
>8%
Recovery/opportunity
>10%
Tracking error concerns fund managers as they often don’t want to take the risk of
being different from the benchmark index, but the absolute risk isn’t necessarily
higher. It is a risk of being different, not a risk of being worse.
Volatility
A common measure of risk. Volatility is one of the most popular measures of risk,
since it can be used to measure market risk for a single financial instrument, a group
of instruments or even an entire portfolio. There are various measures of volatility but
the most common definition used in financial markets is standard deviation (how far
its value varies from the mean). The measure of absolute volatility used for the EIRIS
indices is annualised monthly standard deviation. The volatility of an instrument varies
according to the time period used.
- 64 -
Appendix 1
7.1.1
Total Return Monthly Index Values Dec 1990 - May 1999
Total
Return
Charities’
Avoidance
Index
Environmental
Responders
Damage Avoidance
Index
Index
Ethical
Balanced
Index
Environmental
FTSE
Management All-Share
Index
Index
Dec 90
100.0
100.0
100.0
100.0
100.0
100.0
Jan 91
102.2
101.4
101.8
102.4
101.3
100.9
Feb 91
112.7
112.4
111.5
112.2
111.0
112.4
Mar 91
117.8
118.8
116.2
117.0
116.0
117.1
Apr 91
118.5
120.6
118.1
118.8
118.4
118.5
May 91
118.9
122.1
119.9
119.3
120.5
118.9
Jun 91
115.3
117.9
116.5
114.1
117.2
115.3
Jul 91
124.0
127.2
125.2
123.7
126.0
123.3
Aug 91
127.3
131.5
128.2
126.3
129.2
127.0
Sep 91
128.1
132.9
127.3
127.3
128.3
127.2
Oct 91
127.3
132.3
125.7
124.0
127.2
125.0
Nov 91
122.1
126.3
119.4
117.5
121.0
118.5
Dec 91
126.0
128.1
123.3
117.3
124.7
120.9
Jan 92
130.6
133.4
128.4
122.4
129.3
125.4
Feb 92
132.2
135.0
128.7
124.8
129.7
126.2
Mar 92
126.0
127.9
123.4
115.9
124.8
120.7
Apr 92
137.0
139.1
134.7
128.9
136.0
132.7
May 92
140.3
143.4
138.7
132.7
139.8
136.2
Jun 92
131.6
133.6
130.1
125.2
131.0
126.8
Jul 92
124.5
127.2
125.2
117.1
126.6
119.7
Aug 92
120.5
122.0
121.6
113.0
123.7
115.3
Sep 92
132.4
134.6
133.7
124.5
134.5
127.3
Oct 92
138.6
139.5
138.9
129.8
139.0
133.2
Nov 92
144.7
147.9
145.6
138.4
144.7
139.7
Dec 92
150.8
153.0
150.8
143.6
149.7
145.6
Jan 93
150.9
152.3
149.4
145.2
147.5
146.2
Feb 93
154.1
155.1
153.3
149.5
151.3
150.1
Mar 93
154.8
157.5
156.0
153.2
154.5
151.9
Apr 93
154.2
155.7
153.3
150.6
152.0
150.4
May 93
155.4
158.5
155.1
153.9
153.7
152.4
Jun 93
157.7
162.4
158.3
158.1
156.1
156.1
Jul 93
159.0
162.2
160.8
159.8
158.0
158.4
- 65 -
Total
Return
Charities’
Avoidance
Index
Environmental
Responders
Damage Avoidance
Index
Index
Ethical
Balanced
Index
Environmental
FTSE
Index
Index
Aug 93
170.9
173.3
170.5
170.0
167.3
168.6
Sep 93
168.3
170.7
168.1
168.4
164.1
165.7
Oct 93
175.9
179.2
176.0
176.3
171.2
172.7
Nov 93
174.8
179.5
176.3
176.3
171.1
172.3
Dec 93
188.2
193.7
190.9
191.2
183.4
186.7
Jan 94
194.2
201.4
195.0
197.2
187.4
194.3
Feb 94
188.6
195.5
186.6
189.8
180.5
187.0
Mar 94
176.5
181.1
175.0
177.5
169.7
174.9
Apr 94
176.9
182.4
178.1
177.1
173.2
177.5
May 94
167.5
173.0
169.8
168.9
166.2
169.2
Jun 94
165.2
169.5
167.5
165.7
164.4
165.5
Jul 94
174.6
178.3
177.1
175.2
173.3
175.4
Aug 94
185.6
189.9
188.0
186.0
184.8
185.1
Sep 94
173.0
176.3
175.5
172.8
172.3
172.6
Oct 94
175.9
181.7
180.3
178.1
175.8
176.0
Nov 94
176.4
181.3
179.3
176.5
174.9
175.7
Dec 94
177.2
181.3
178.9
175.7
175.1
175.5
Jan 95
172.9
176.6
175.4
172.6
171.5
171.4
Feb 95
174.6
177.0
175.6
173.0
171.5
172.7
Mar 95
181.2
185.7
184.8
179.9
180.4
180.2
Apr 95
186.1
190.1
190.3
184.1
185.5
185.5
May 95
193.3
197.4
195.9
191.3
190.5
192.6
Jun 95
193.5
198.7
196.0
191.8
190.1
192.1
Jul 95
203.0
208.2
205.6
202.6
198.8
202.0
Aug 95
206.0
212.8
207.1
206.5
199.6
204.8
Sep 95
207.3
215.0
208.7
207.6
200.5
207.6
Oct 95
208.7
217.7
209.7
206.6
199.2
208.1
Nov 95
214.5
223.9
218.3
213.1
204.3
215.2
Dec 95
216.7
224.5
221.9
214.0
208.6
218.0
Jan 96
221.3
229.3
225.8
215.9
211.6
223.4
Feb 96
219.2
230.4
225.5
217.5
210.9
223.8
Mar 96
220.1
231.8
224.6
221.1
211.8
225.7
Apr 96
231.7
243.3
232.3
232.4
218.9
235.4
May 96
229.0
242.3
229.2
230.1
215.1
232.6
Jun 96
226.4
238.7
227.9
225.6
213.6
229.8
- 66 -
Total
Return
Charities’
Avoidance
Index
Environmental
Responders
Damage Avoidance
Index
Index
Ethical
Balanced
Index
Environmental
FTSE
Index
Index
Jul 96
223.8
236.1
228.1
220.8
214.5
228.1
Aug 96
234.6
248.4
238.4
232.0
223.4
239.5
Sep 96
237.5
249.7
243.1
231.0
228.9
244.0
Oct 96
239.8
253.6
245.5
237.3
228.8
245.9
Nov 96
245.6
258.7
252.0
244.8
234.1
250.0
Dec 96
249.5
263.6
256.5
249.5
237.4
254.4
Jan 97
259.5
274.2
265.6
257.9
244.1
264.0
Feb 97
264.8
279.7
268.0
261.1
243.7
267.1
Mar 97
264.5
278.5
269.9
257.3
248.9
267.8
Apr 97
271.3
286.3
278.6
263.5
254.5
273.5
May 97
277.4
293.1
289.1
268.8
262.4
282.8
Jun 97
274.8
287.1
290.5
264.5
267.5
281.7
Jul 97
288.3
299.1
309.1
277.2
283.6
295.9
Aug 97
287.4
301.7
306.5
279.1
282.1
294.7
Sep 97
308.1
324.4
334.8
298.8
306.5
318.6
Oct 97
296.0
309.5
313.0
290.8
290.4
298.0
Nov 97
300.5
313.0
311.7
297.3
288.8
297.7
Dec 97
318.2
332.3
332.0
313.1
303.9
313.9
Jan 98
343.3
358.3
351.5
338.7
319.3
330.9
Feb 98
359.9
380.3
369.3
355.7
331.3
350.5
Mar 98
369.6
392.6
380.1
367.2
343.6
365.5
Apr 98
369.5
391.7
382.2
363.9
351.9
367.2
May 98
374.8
396.4
381.0
370.4
349.7
369.6
Jun 98
372.3
395.5
377.8
372.1
350.3
362.6
Jul 98
372.5
404.9
377.5
381.6
349.8
360.2
Aug 98
344.5
363.0
339.4
344.4
321.7
324.2
Sep 98
333.9
342.0
331.2
329.2
319.6
312.2
Oct 98
351.6
364.1
357.5
345.2
336.7
334.0
Nov 98
365.0
384.5
375.3
360.4
349.4
350.9
Dec 98
374.6
395.1
384.9
366.6
360.3
357.6
Jan 99
385.2
413.8
380.6
376.4
350.6
360.7
Feb 99
394.2
433.2
401.2
393.2
369.9
378.6
Mar 99
397.9
434.3
413.8
394.9
385.1
390.3
Apr 99
402.9
454.8
432.8
415.3
398.9
409.2
May 99
391.5
434.0
412.7
396.7
382.5
391.0
Total return = capital plus income
- 67 -
Feedback
EIRIS would be very interested in any comments you might like to make about the issues
raised by this paper or about its research in this area. Please send any comments to:
Ros Havemann
Projects & Publications Manager
EIRIS
80-84 Bondway
London
SW8 1SF
Tel:
0171 840 5702
Fax: 0171 735 5323
E-mail: [email protected]
- 68 -

Does Ethical Investment Pay

Transcription

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