Research: Ethical investment options

International developments
While the term is relatively new, forms of ethical investing have been around for a long time. The first users of this philosophy were religious groups. More recently, some fund managers in the US and elsewhere have created dedicated ethical funds in order to attract business.

US Experience
Small specialised ethical funds comprise perhaps 1% of total funds under management - approx. US$150 billion (Social Investment Forum). On a broader definition there are about 10% of funds under management, US$1.5 trillion, which would be classed as "socially responsible".

Studies show nil to modest gains (on risk-adjusted basis) in performance.

A 1998 study of 183 socially responsible US funds (from a universe of 9,805 funds) by Social Investment Forum & Wiesenberger had the following key results:

• gross returns 1-2% per annum higher,


• gross risk 3% per annum higher, and


• expenses 20 basis points higher.

Our own analysis of 67 ethical funds (45 of these were US equities) with total funds under management of $16 billion, compared their 1 and 3 year gross returns to 31 May 2000 with the appropriate indices. The results on an asset-weighted basis varied by sector and period, and of course depended on the selected indices. The ethical funds added significant value over 1 year (6% to11%) but added little over 3 years (-1% to 3% pa).

UK Experience
In response to growing interest in ethical investing in the UK, the Labour government has introduced a regulation to the Pensions Act 1995 (effective from 3 July 2000) requiring pension fund trustees to declare their ethical stance. It seems certain that ethical funds will comprise a larger share of total funds.

Australian Experience
Australia also has dedicated ethical funds, albeit smaller than in UK or US. One practical difficulty faced in Australia is the large number of mining companies.

The recently announced Westpac-Monash Eco Index is an indication of growing interest in environmental aspects of investment.

Our analysis applied ethical judgements to each of the 500 largest companies, based mainly on industry classifications rather than company knowledge. On a market capitalisation basis our analysis revealed:

• about 55% pass the most stringent screens,


• about 22% fail the ethical tests, and


• about 23% might pass the screening depending on the degree of acceptable ethics.

The table in the next column shows the results for each test. We expect that the proportions failing are slightly understated.

New Zealand Situation
To our knowledge there are currently no major funds marketed as ethical in New Zealand. This does not mean that there are no ethical investments, rather that each investor or pension fund wishing to invest ethically has had to include a constraint in their Statement of Investment Policies and Objectives, or self-manage the stance.

The NZ sharemarket is acknowledged to be concentrated in few stocks and is illiquid compared to other sharemarkets. Therefore ethical funds face diversification problems.

New Zealand Analysis
We have analysed New Zealand listed companies to gauge how many companies appear to fail ethical screens, to determine diversification impacts.

The analysis is not straightforward as many smaller companies are shells, and requires considerable judgement. On a market capitalisation basis our analysis revealed:

• 35% of the NZSE10 and 46% of the NZSE40 pass the most stringent screens,


• 20% of both the NZSE10 and NZSE40 fail the ethical tests, and


• 45% of the NZSE10 and 35% of the NZSE40 might pass depending on the degree of acceptable ethics.

Of the 52 securities in the NZSE40, 7 fail the ethical screening test and a further 6 are borderline. Clearly a strong stance reduces diversification and hence increases risk. The impacts on returns have not been assessed, but are expected to have varied between positive and negative depending on the time period analysed.

The results are set out in the table below.

Practical issues
People wishing to invest in an ethical manner must either choose a specialised ethical fund/manager (not currently available in New Zealand) or include ethical restrictions in the investment mandate. Where the investor specifies the securities to be excluded managers will generally charge standard fees. If the investment manager is required to apply ethical screening a fee will generally be charged for the service.

If a fund manager is required to have regard to ethical considerations then the usual monitoring needs to be adjusted. Firstly, the investor should check that the ethical stance is being followed. Also standard indices may not be an appropriate indication of manager performance. By having an ethical index, constructed in an identical manner to a standard index but excluding unethical investments, the manager performance can be separated from the value added or lost by taking the ethical stance. There are no ethical indices in New Zealand but other countries, such as the US, do have them.

Due to the lack of diversification in the New Zealand sharemarket and the relatively high levels of black marks (or grey ones), investors who are concerned about ethical issues may consider using a specialised Australian ethical fund as the investment vehicle.

Mark Weaver is a principal of consulting actuaries Melville Jessup Weaver.

Mark Weaver is a principal at consulting actuaries Melville Jessup Weaver.

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