Windmaster Nordex

In the aftermath of the credit crunch, there was much hoopla about  the ethical sector as governments around the world made bailouts  conditional on green initiatives. As austerity became the watchword, it  went very quiet - principles started to seem like a luxury.

But  the chaos at the Fukushima nuclear plant in Japan has diverted the  attention of governments and investors alike back on to alternative  energy and green issues in general. This has been good news for share  prices of renewable energy companies and for the ethical sector.

Charlie Thomas, a fund manager in the SRI & governance team at Jupiter Asset Management,  says: "The problems at the nuclear reactor plant in Japan have had an  impact. There is likely to be lower nuclear rollout going forward and  this has generated movement in the share prices of alternative energy  providers.

"Vestas Wind Systems, for example, is up around 30%,  Nordex is also higher. The solar companies have risen by anything up to  100%. Partly this is due to sentiment, but it also reflects policy  change on the part of European governments."

However, prices in  the alternative energy sector had been knocked back over the past year  by waning government support for the sector, so they are coming from a  low base.

Ryan Smith, head of corporate governance at Aegon, says  2010 was tough: "There simply wasn't enough money to be spent. There was  a softening of energy policy and renewables targets. Spain and Italy  had strong renewables markets and therefore companies suffered from  their weakness."

Therefore, the recent strength of the renewables  market has not translated into significant outperformance by the wider  ethical fund sector.

Equally, the sector hasn't benefited as much  as might be expected from the boom in small and mid-cap shares over the  past 12 months. On average, ethical funds have performed worse over  three years than the UK all companies, global and UK equity income  sectors.

That said, it is not like the bad old days of having to  sacrifice profit for principle - on average the funds have  underperformed by around 2% to 4% and many funds compete and hold their  own against non-ethical funds. This is in spite of having largely missed  out on the commodities boom that has dominated markets in recent years.

On rare occasions, the screening has actually helped. The Aegon UK Equity and Aegon Ethical Equity funds, for example, are run using the same process, yet the ethical fund is ahead over one and three years.

A disparate sector

There  has been little apparent pattern to the type of ethical funds that have  outperformed or underperformed. The sector is disparate: it includes  'light green' or 'dark green' funds (light focus on engaging with  companies to improve their ethical performance, while dark exclude  certain companies); funds with a different geographical focus, including  UK, Europe or international; funds focused on different environmental  areas, such as energy or climate change; and funds looking at "social  responsibility", investing in companies that try to do good, rather than  specifically excluding companies.

For more on the sector, read: Are saintly investments for you?

Amanda  Davidson, a director at adviser Baigrie Davies, says that performance  within the sector tends to vary according to the manager and the extent  to which the green criteria limit the amount of stocks available for  investment: "Performance tends to come down to good or bad managers.

"But  if you have a fund that excludes so much, you can get problems with  performance because the universe of shares is small. In general, when  banks, mining or tobacco companies are doing well, ethical funds will  underperform because they don't hold them."

Ethical funds sit  across a variety of IMA sectors - largely in UK all companies and global  growth, although they also appear in a number of the bond sectors. The  top and bottom-performing funds sit across a variety of these sectors.

Of  the 19 ethical funds that are third or fourth-quartile over one and  three years, six are in the UK all companies sector, seven in the global  growth sector and the remainder spread across other equity and bond  sectors.

Although ethical funds have matured, it is still  generally a small and mid-cap focused area - larger companies have too  many moving parts and therefore struggle to meet ethical criteria.

Lee  Clements, investment manager at Impax Asset Management, says that some  larger companies are moving in, often through takeovers, seeing it as a  high-growth, high-margin area. They are picking up this "leaders" theme  across a number of their portfolios.

The key area for fund  managers over the past year has been in energy efficiency. This is where  shares have performed best. Clements says: "Energy-efficiency companies  may provide high-efficiency lighting or process automation. They have  been driven by legislation or industrial standards and they haven't had  to rely on government subsidies."

Ethical managers are predicting  better times ahead for the sector. Thomas, for example, believes that  share prices within the renewables sector have further to go: "The  previous energy boom in 2008 was driven by high oil and commodities  prices. We now have concerns on the nuclear issue, emerging markets  growing strongly and Middle Eastern instability. It is a much more  powerful story than in 2008 and it is not reflected in valuations."

Other  sectors favoured by ethical managers may be beneficiaries of the high  oil price, notably the transport sector. As fuel becomes more expensive,  companies and consumers are increasingly looking at ways to be more  energy efficient and cut transport costs.

However, energy is not the only game in town and there are other themes running through the majority of ethical portfolios.

Thomas  says the ethical consumer, for example, has not been deterred by the  economic gloom and ethical produce is still increasing its proportion of  trolley spend. Clements adds that water and waste companies still  feature significantly across its portfolios.

Of course, there  remains a question as to whether specific ethical funds should exist at  all. In the aftermath of the banking crisis, there have been a number of  initiatives aimed at increasing shareholder engagement. Fund management  groups should, in theory, be implementing ethical criteria into their  day-to-day risk management.

However, Darius McDermott, managing  director of Chelsea Financial Services, says: "I have never heard a UK  equity manager saying that they are investing for ethical reasons. They  simply don't mention it."

Davidson says that it all depends on the  sway of the ethical manager within the firm. She says: "An ethical  manager may advise against buying, say, BP (BP.)  because it doesn't like the attitude of management and that will be  picked up by other managers. It depends how plugged in the ethical  manager is with the rest of the team."

For the time being,  therefore, ethical funds still have their place. Thomas says the sector  has been reinvigorated over the past year: "There was an argument in  2007/2008 that investing in a green way was just a 'nice to have', now  it is a 'must have'.

"There are issues of energy security,  resource scarcity, which are all beginning to change the way people are  looking at this area. There is population growth and consumer trends are  beginning to shift. There is a lot going on."

Two funds and a trust with compelling green themes

Aegon Ethical Equity

One  of the most successful of the mainstream funds in the ethical arena, it  is top-quartile in the UK all companies sector over five years. It's a  'dark green' fund, managed by Audrey Ryan.

Independent ethical  research group EIRIS compiles a list of firms that meet certain ethical  criteria from which Ryan can select. It screens out areas such as animal  testing, arms, gambling, alcohol and tobacco.

The fund is run in line with Aegon's standard UK equity process, but will tend to be overweight small and mid-cap stocks.

Ecclesiastical Amity International

One  of a series of funds run by Robin Hepworth, it is one of the  longest-established funds in the sector, having launched in 1988.

This  fund has positive and negative criteria, investing in those companies  that make a positive contribution to society and the environment through  sustainable and socially responsible practices and avoiding companies  involved in alcohol, tobacco and weapons production.

Hepworth's  style is to manage with a long investment horizon and low turnover. He  aims to know all the companies within his portfolio very well, rather  than having to source a lot of new ideas.

Impax Environmental Markets

The trust was launched in 2002 and is structured as a UK-listed investment trust.

The  team of managers at Impax Asset Management focus on four main areas -  renewables, energy efficiency, water and waste - aiming to generate  returns from the growth in the environmental sectors.

It is focused on the larger and more profitable end of the market, only holding around 5% in unprofitable companies.

At  the moment, the trust is particularly focused on energy efficiency  companies, where the managers believe the greatest opportunities lie.  Its largest holiding is Regal Beloit (RBC), an electronics manufacturer.

This article was taken from the May 2011 issue of Money Observer.