Is ethical investing the next wave?

The explosion of ethical funds has come at a time of increasing interest and the search for new sectors in which to invest. Mark Watmore examines the growth of this market and the drivers behind it.

Is Australia ready for ethical investing? Research, including that done with financial planners, suggests we are but how quickly the market grows depends on a number of issues.

One good indicator is the number of better known 'brand name' fund managers, such as AMP, Westpac and Rothschild, which have embraced the concept with the launch of ethical or socially responsible funds. The major fund managers believe the rise of the ethical investment market overseas is likely to be mirrored here, especially with fund choice waiting in the wings.

Another indicator is if the gatekeepers, such as financial planners, believe there is a client demand for ethical investment products. Research carried out by Rothschild indicates there is and prompted the fund manager to recently launch two wholesale ethical investment trusts accessible to retail investors through master funds.

Ethical investing, sometimes referred to as green, socially responsible (SR) or conscious investment, is best defined as the integration of personal values with investment decisions.

It has its origins in church funds some 50 years ago. From the turbulent so called anti-establishment period of the '60s and early '70s grew a number of socially concerned investors who were very discerning about what companies they invested in.

What started off as more of a symbolic and often emotional response to investment became an established form of investing as managed funds saw a customer driven demand in the market for robust ethical or socially responsible funds.

From its grass roots beginnings, North America and the UK have seen assets dedicated to ethical and SR investment grow by 50 per cent per annum over the last 10 years. Research quotes that one in every eight dollars invested in managed funds in the US is screened from an ethical or social perspective.

It is worth looking at the Canadian situation as it has a similar managed funds market to Australia. Four screened managed funds with a little over A$102 million in net assets were available in 1989. By 1998 this had grown to 14 screened mutual funds comprising A$3.8 billion in net assets. This was an increase of 37 times compared to unscreened funds growing only 14.5 times over the same period. This suggests considerable scope for growth in Australia even with a fraction of this level of interest.

There is currently more than $400 million invested in ethical products in Australia. Growth has been slow but interest has increased significantly in recent times along with considerable media coverage. A Resnik-KPMG survey indicated that if given the opportunity to choose the investments of their super fund 69 per cent of Australians would consider investing in a SR fund.

There are two main approaches to ethical investment, negative screening in which unethical investments are avoided, and positive screening which seeks out environmentally and/or socially responsible investments such as green and sustainable technologies.

Common screens used in an ethical portfolio include environmental, human rights, community citizenship, workplace practices, animal welfare, corporate governance, gambling, alcohol, tobacco, weapons and uranium.

Australia has been slower in embracing the concept of ethical investment compared to the US and the UK.The present local market is relatively small. It is estimated that less than four per cent of adult Australians with assets (apart from their homes) already have super or non-super investments in an ethically screened managed fund.

The reluctance to invest in ethical or SR investments was due to a number of reasons, including the dominance of the mining and energy sector in the domestic share market until recent years, and the belief amongst many investors that returns in such investments will be lower. A consistent comment has been that there is a lack of high quality products in this area in Australia.

However, in just over a year the awareness and interest in ethical and SR investment in Australia has accelerated. This includes activities such as:

Major superannuation bodies such as HESTA, UniSuper and VicSuper offering ethical/SR screened investment options;

Australia's largest master fund operator Asgard adding funds to its investment menu;

ASFA opening up the debate to its members;

The establishment of Australia's first environmental index, the Eco-Index;

Increasing research demonstrating the positive outcomes of ethical investment; and

The plan of a number of major fund managers to release ethical or SR managed investments on the local market.

A major stumbling block for investors was the belief that screened funds delivered poor returns. This was the initial problem in the United States and is seen as being a key issue in Australia. However, investor awareness of the nature of companies they invest in has contributed to a realisation by investors that their altruism can be profitable. For instance, investors see good environmental management as a key to good overall management of a company.

In fact, research from the United States in 1998 showed that over one, three, five and 10 years, the performance of ethically screened funds was up to 30 per cent better than non-screened funds.

Even after the burst of the tech bubble last year 12 of the 17 socially and environmentally screened managed funds with US$100 million or more in assets earned high ratings from either or both of two of the industry's respected investment tracking firms: Morningstar and Lipper. In addition, of the 65 SR funds tracked by Morningstar 11 per cent received the firm's coveted five star rating and 26 per cent gained a four star rating.

As stated above, a key to market acceptance in Australia is the so-called gatekeepers: retail and masterfund advisers, researchers and institutional consultants. Rothschild undertook a survey of some 2000 financial planners and 100 institutional key decision makers during January 2001.

The survey signals a definite positive shift in interest by both the retail and institutional markets with the gatekeepers very clear on where they see the demand for such funds and how they want them implemented.

The majority of gatekeepers in both retail or institutional are either already using the limited number of ethical funds available in Australia or had considered using them, according to Rothschild's survey.

When asked of their involvement with SR/Ethical investing for their clients, retail and masterfund advisers responded with nearly half (49 per cent) saying they had considered using the funds, just over a third (34 per cent) had not considered using them and the remainder (17 per cent) stating they were currently using ethical investments.

Many retail respondents said their consideration of such funds was client-driven, while some institutional respondents said whether they recommend such funds or not would be dependent on the performance of the fund compared to the standard Australian equity products on the market.

Financial planners saw a retail and wholesale trust option for masterfunds as the preferred product, while asset consultants and institutional researchers saw member choice as the key to offering ethical investment options.

Financial planners, according to the survey, prefer both domestic and international share offerings as the preferred sectors for ethical SR/managed fund investing

Both the retail and institutional gatekeepers were clear on the make up of the funds. They wanted the funds screened and they were clear on areas they felt were important to screen. They also prefer a combination of both positive and negative screening for such funds. 43 per cent of respondents in both areas of the market preferred this combination.

When asked which particular areas they felt important to screen, both areas of the industry ranked the areas similarly. In retail the areas ranked in order of importance were environment, human rights, tobacco, gambling, alcohol and labour relations.

There is little doubt there is demand for ethical or socially responsible investment funds in Australia. We are unlikely to see the same extensive embracement of the concept as we have seen in North America, but as Rothschild's research indicates, both the retail and institutional sectors of the financial services market are well versed in the concept.

The retail market in this area is still primarily client driven, and while the some of the major superannuation funds are showing strong interest the market seems to be waiting for a catalyst for Australian investors to be more comfortable with the concept that ethically investing is profitable.

That catalyst is likely to come from key, brand name fund managers demonstrating that such funds are not fringe dwellers in the market place, but robust investment products that can match the performance and wealth creation ability of the traditional products

With the present level of interest, ethical investing is undoubtedly going to become an accepted part of the Australian investment landscape in the very near future.

Mark Watmore is the product development manager for Rothschild Australia

Asset Management