It's not easy being green… but it is popular

Despite what you’ve heard, ethical investing hasn’t moved in from the sidelines. It hasn’t even come close. What’s more, it’s pretty likely that what you think you know about ethical investing has very little to do with ethics at all. Responsible Investment Association Australasia’s (RIAA) latest benchmark report shows that total funds under management in ‘responsible’ investment portfolios as at December 2012 stood at $152 billion, or 16% of total assets under management in Australia, double what it was in 2010.

Most of the coverage the report received over the past week and a half seems to suggest that RIAA’s report is proof that ethical investing has achieved mainstream status. But lumping ethical and ‘responsible’ investing together, while looking better on paper, doesn’t do ethical investing any favours.

“The growth of the responsible investment space in general is a bit of a double-edged sword,” says Paul Smith, general manager of strategy & communications for Australian Ethical. “The growth has all come from ESG (Environmental, Social and Governance) integration. The danger is it becomes a ‘tick box’ that people may not fully understand. They may see ESG and think ethical.

“I would say ESG is one of the factors that may have hindered the growth of ethical investment in this country,” Smith says.

ESG versus ethical

The growth of ESG is quite remarkable. As you can see from the chart below, it now represents 89% of the total FUM of ‘responsible’ funds, or $135 billion, and grew a staggering 33% in the 12 months to December 2012 alone.

Source: RIAA

But ESG is in no way the same as ethical.

There’s no ethics-based value in ESG investing. The priority is the integration of environmental, social and governance factors into the financial decision making. It’s all about the future shareholder value and the potential ESG risks that could affect a company’s share price down the line. Obviously this approach makes it easier for funds and investors to digest.

But where does that leave ethical investing?

Ethical and socially responsible portfolios saw funds under management rise 4.2% in 2012, from $14.6 billion to $15.2 billion. These funds now account for just 1.63% of the $934 billion in total assets under management (TAUM) in Australian funds. At June 2011 they made up 1.76% and at June 2010 it was 1.67%. In 2005 it was 1.15%.

“The ethical and the socially responsible funds have really just flat-lined for quite a few years in terms of FUM and as a percentage of total assets under management,” says RIAA chief executive Simon O’Connor.

“I think it’s safe to say the wider community does not understand the difference and the complexity [between ESG and ethical funds],” he says.

While RIAA is focused on educating investors’ on the difference between ESG and ethical investing, combining them into the same report certainly doesn’t help the situation.

Positive and negative screening

Unlike ESG, ethical investing is centred around whether or not an investment can be deemed ‘ethical’. The vast majority of ethical funds apply a negative screen to investments, meaning they will not invest in a range of industries including tobacco, gambling, guns, uranium or old growth logging. Some also apply a positive screen, meaning some of their investments will be in companies that contribute in a positive way to the environment or society.

Australian Ethical is the only ethical fund in the country to apply a positive screen to all of its holdings.

The prevalence of ESG over negative screening here is in stark contrast to the rest of the developed world, as detailed in a report issued earlier this year by the Global Sustainable Investment Review. The GSIA report found that while negative/exclusionary screening is the most popular technique used by ethical funds globally, with US$8.3 trillion in assets, it represents just a fraction of Australia’s sustainable investing, at 6.4%. One reason for this could be because Australia has such a concentrated sharemarket, says Smith. Stripping out ‘sinful’ stocks leaves our funds with a much smaller universe to invest in than their counterparts would have in Europe or the US.

So ethical funds have had to fight a long battle in this country to convince investors that a smaller universe doesn’t equal reduced returns. And with an ethical fund getting the number one spot in 2012 (Perpetual Wholesale Ethical SRI Fund returned 38% over the year) they certainly seem to have a case.

Despite this, as you can see from the chart below, the number of funds undertaking negative screening is actually on the decline, falling 1% from 2011 to 2012. Diminishing from such a low base is a worrying trend, although positive screening is making up for it, rising 13% over the year.

Source: RIAA

Still, as a proportion of the segment, screening is still woefully small. Both positive and negative screening are undertaken by just 8% of so-called ‘responsible’ funds compared to the 89% that focus on ESG integration.

Where to draw the line?

Ethical funds have their issues too. As has long been debated, there is no one standard employed across all ethical funds. While Perpetual scored the number one spot last year, seven of its top 10 holdings are the same as one of its mainstream funds, the Perpetual Wholesale Share Plus Fund.

Perpetual’s ethical fund employs a negative screening process. It excludes BHP Billiton and Woolworths, but explosives supplier Orica is fine, as is coal freight group Aurizon.

Perpetual’s strategy is different to Australian Ethical, which has a zero-tolerance approach to a number of industries.

Then again, a diehard fanatic would probably find issue with every single listed company if they tried hard enough. The line has to be drawn somewhere, but with each ethical fund drawing the line at a different place, it’s not surprising there’s an enduring element of cynicism when we talk of ethical funds.

Of the lot, Australian Ethical is the front-runner when it comes best meeting the standards implied by its name. It takes what some would call a hard-line approach and is zealous about investing in companies that make a positive contribution to society.

Small steps

ESG may be seen as a step in the right direction but it seems a very, very small step, since integrating ESG processes into the financial analysis of a company doesn’t necessarily mean a different outcome when deciding to hold that company in the portfolio. The point of ESG is to deliver better returns by reducing certain risks; it makes good business sense without necessarily bringing ethical considerations into the equation.

For anyone looking to invest in an ethical, green, socially responsible or ‘responsible’ fund, make sure to read the fine print.