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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

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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 Calvert Social Investment Fund Managed Index Portfolio .............................................27

4 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 "sub-

optimal" 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

- 1 - © 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.


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

0

500

1000

1500

2000

2500

£m

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

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 three-

quarters 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”.


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


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

Government legislation

COMPANY- strategy

Customers Shareholders

Company sales- price- volume- market share

Cost of capital

SHARE PRICE

Cash flow

Company costs- productivity- costs- supplier relations

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 John Kay, Good Business, March 1998 5 Centre for Tomorrow’s Company, The Inclusive Approach and Business Success

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


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


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


2.3 Portfolio effects

Figure 4: The effects of ethical investment on a portfolio

Ethical policy and approach

Fund manager "fit"

Missed opportunities

Concentration/ churn

Research costs

Sector and stock effects

CommitmentStyle

PORTFOLIO PERFORMANCE

Tracking error

VolatilityDiversification

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


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. Shorter-

term 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


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 long-

term 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


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.


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 All-

Share 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).


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.


•

•

•

•

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

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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.


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


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3.4 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


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

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Responders FTSE All-Share Index

3.5 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


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


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Ethical Balanced FTSE All-Share Index

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


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 1990-1999

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Environmental Management FTSE All-Share Index


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

% of FTSE All-Share Index by market value

Charities’ Avoidance Index 534 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%

Table 2: Industry group structure May 1999

Industry Group Charities’ Avoidance

Environ-mental

Damage Avoidance

Responders Ethical Balanced

Environ-mental

Mgement

FTSE All-

Share

Resources

1.2% 0.0% 15.4% 0.3% 19.5% 11.6%

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

0.2% 0.4% 0.8% 0.5% 1.0% 0.7%

Non-Cyclical Consumer Goods

25.3% 16.6% 21.8% 9.1% 28.0% 17.3%

Cyclical Services

22.0% 21.7% 13.2% 21.2% 8.9% 16.9%

Non-Cyclical Services

11.2% 21.5% 11.7% 21.0% 11.4% 12.6%

Utilities

8.2% 2.3% 5.8% 8.5% 7.5% 4.6%

Information Technology

1.4% 2.3% 0.5% 1.5% 0.0% 1.4%

Financials

24.5% 32.6% 24.2% 35.2% 15.6% 26.7%

TOTAL

100.0% 100.0% 100.0% 100.0% 100.0% 100%


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

Environmental Damage

Avoidance

Responders Ethical Balanced

Environmental Management

FTSE All-

Share 1991 26 28 23 17 25 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

0.08%

1.61%

0.53% 0.34%

-0.61%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

CharitiesAvoidance

EnvironmentalDamage

Avoidance

Responders EthicalBalanced

EnvironmentalManagement

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.


Figure 11: Annual tracking error 1990 -1999

3.3% 3.2%

2.5%

4.0% 3.9%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

CharitiesAvoidance

EnvironmentalDamage

Avoidance

Responders Ethical Balanced EnvironmentalManagement

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 R-

squared ranged from 91.6% to 96.6%.


Figure 12: Annual index volatility

12.4%

13.7%

13.2%

13.7%

12.1%

13.5%

11.0%

11.5%

12.0%

12.5%

13.0%

13.5%

14.0%

CharitiesAvoidance

EnvironmentalDamage

Avoidance

Responders EthicalBalanced

EnvironmentalManagement

FTSE All-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 All-

Share 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


“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


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 non-

ethically screened tracker fund, but lower than an actively managed non tracker fund.


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.


Table 5: Funds covered, showing sectors, first period covered and number of 5-year periods

Name of fund (July 98) Sector Start of

first 5-year period

No of 5-year

periods

Abbey Ethical UK Growth 01/01/88 12 Allchurches Amity UK Growth 01/07/88 11 Credit Suisse Fellowship UK Growth 01/01/92 14 Friends Provident Stewardship UK Growth 02/07/84 19 Scottish Equitable Ethical UK Growth 03/07/89 9 Sovereign Ethical UK Growth 03/07/89 9 TSB Environmental Investor UK Growth 03/07/89 9 Friends Provident Stewardship Inc UK Income 01/01/88 12 Aberdeen Prolific Ethical International Growth 01/01/93 2 CIS Environ International Growth 01/07/90 7 City Financial Acorn Ethical International Growth 02/01/89 10 Clerical Med Evergreen International Growth 02/07/90 7 Framlington Health International Growth 01/07/87 13 Jupiter Ecology International Growth 01/07/88 11 NPI Global Care International Growth 01/01/92 4

Total 149

4.3 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


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


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.


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


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

Name of fund (July 98) Number

of 5-year periods in study

Sector average

5-year returns

Difference in fund's average returns

against the average

Sector median

5-year returns

Difference in fund's average returns

against the median

UK growth sector=Abbey Ethical 12 10.07 -0.44 10.10 -0.46 Allchurches Amity 11 10.49 -1.80 10.27 -1.58 Credit Suisse Fellowship (*) 14 9.05 -1.39 9.10 -1.43 Friends Provident Stewardship(*) 19 10.32 0.01 9.87 0.46 Scottish Equitable Ethical(*) 9 10.95 -0.62 10.64 -0.32 Sovereign Ethical 9 10.95 -1.58 10.64 -1.28 TSB Environmental Investor 9 10.95 -0.17 10.64 0.14

UK income sector=Friends Provident Stewardship Inc 12 10.37 -2.22 10.16 -2.01

International growth sector=Aberdeen Prolific Ethical 2 11.06 -0.41 10.53 0.11 CIS Environ(*) 7 12.24 0.70 11.34 1.60 City Financial Acorn Ethical 10 11.34 -1.87 10.28 -0.81 Clerical Medical Evergreen 7 12.24 -6.65 11.34 -5.74 Framlington Health 13 10.35 10.82 9.88 11.28 Jupiter Ecology 11 11.14 -1.12 10.27 -0.25 NPI Global Care(*) 4 12.54 -0.65 11.66 0.22

All ethical funds 149 -0.49 -0.01

All excluding Health & Evergreen 129 -0.89 -0.43 Larger funds (*) excluding Health & Evergreen

53 -0.39 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.


• 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

Name of fund (July 98) Number

of 5-year

periods in study

Average percentil

e of 5-year

returns

Standard deviation of fund's

returns

Sector average

standard deviation

Percentile of sector

with lower "risk"

UK growth sector Abbey Ethical 12 43% 2.05% 4.05% 1% Allchurches Amity 11 24% 2.51% 3.99% 10% Credit Suisse Fellowship(*) 14 42% 8.32% 4.68% 97% Friends Provident Stewardship(*) 19 47% 5.36% 5.80% 56% Scottish Equitable Ethical(*) 9 40% 2.91% 4.00% 24% Sovereign Ethical 9 31% 4.55% 4.00% 75% TSB Environmental Investor 9 50% 3.76% 4.00% 54%

UK income sector Friends Provident Stewardship Inc 12 25% 3.31% 3.33% 59%

International growth sector Aberdeen Prol Ethical 2 52% 0.47% 0.58% 50% CIS Environ (*) 7 64% 1.61% 2.89% 1% City Financial Acorn Ethical 10 37% 2.79% 3.65% 10% Clerical Medical Evergreen 7 1% 2.84% 2.89% 50% Framlington Health 13 97% 6.34% 4.81% 90% Jupiter Ecology 11 44% 3.55% 3.57% 54% NPI Global Care (*) 4 50% 0.61% 2.04% 4%

All ethical funds 149 43% 42% All excluding Health & Evergreen 129 42% 38% Larger funds (*) excluding Health & Evergreen

53 49% 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.


• 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".


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

Average percentage returns compared

with median fund in each sector

Percentile ranking (%) compared with all other funds in

sector All= Ex

sector funds=

Larg-est 5 funds=

All= Ex sector funds=

Larg-est 5 funds=

All = Ex sector funds=

Larg-est 5 funds

3/7/89 1 0.73 0.73 0.73 2.00 2.00 2.00 68% 68% 68% 1/1/90 1 0.96 0.96 0.96 1.91 1.91 1.91 69% 69% 69% 2/7/90 1 -0.34 -0.34 -0.34 0.25 0.25 0.25 53% 53% 53% 1/1/91 1 -0.54 -0.54 -0.54 -0.09 -0.09 -0.09 50% 50% 50% 1/7/91 1 0.21 0.21 0.21 0.09 0.09 0.09 51% 51% 51% 1/1/92 2 -2.77 -2.77 -2.77 -2.78 -2.78 -1.85 31% 31% 31% 1/7/92 3 1.56 -3.12 -3.12 0.89 -4.19 -2.80 50% 25% 25% 1/1/93 5 2.21 -1.73 -3.19 1.85 -2.38 -2.73 45% 31% 23% 1/7/93 7 0.81 -1.27 -3.53 0.37 -1.82 -2.95 46% 37% 21% 3/1/94 8 -0.20 -2.23 -3.06 -0.12 -2.26 -2.42 38% 29% 24% 1/7/94 11 -0.38 -1.33 -1.45 -0.59 -1.61 -1.50 39% 33% 32% 2/1/95 11 0.23 -0.89 -1.18 0.15 -1.06 -1.24 45% 39% 35% 3/7/95 13 -0.17 -0.58 0.49 0.06 -0.41 0.52 45% 44% 53% 1/1/96 13 -0.02 -0.90 -0.05 0.64 -0.31 0.45 45% 44% 55% 1/7/96 13 1.10 0.60 2.02 1.78 1.27 2.18 60% 62% 76% 1/1/97 14 -0.64 -0.65 0.59 0.18 0.10 1.17 46% 47% 62% 1/7/97 14 -2.10 -2.55 -1.48 -1.57 -2.06 -0.79 24% 20% 30% 1/1/98 15 -1.08 -1.09 -0.08 -0.46 -0.48 0.47 42% 42% 53% 1/7/98 15 -0.62 -0.73 0.61 -0.38 -0.51 0.69 46% 46% 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.


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

Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89

To Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94

UK growth sector Abbey Ethical 73% 71% 62% Allchurches Amity 67% 45% Credit Suisse Fellowship(*)

6% 6% 14% 8% 12%

Friends Provident Stewardship(*)

68% 69% 53% 50% 51% 56% 44% 33% 34% 36%

Scottish Equitable Ethical(*)

Sovereign Ethical TSB Environmental Investor

UK income sector Friends Provident Stewardship Inc

5% 4% 4%

International growth sector

AberdeenProl Ethical CIS Environ(*) City Fincl Acorn Ethical 16% Clerical Medical Evergreen

Framlington Health 100% 100% 100% 100% Jupiter Ecology 35% 26% NPI Global Care(*)

Averages by time period

All ethical funds 68% 69% 53% 50% 51% 31% 50% 45% 46% 38% All funds ex Health & Evergreen

68% 69% 53% 50% 51% 31% 25% 31% 37% 29%

Largest 5 funds (*) ex Health & Evergreen

68% 69% 53% 50% 51% 31% 25% 23% 21% 24%


Table 9 (continued)

Time Period: From

Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Average

To 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 66% 69% 49% 56% 42% 12% 4% 5% 6% 43% Allchurches Amity 31% 41% 27% 12% 10% 12% 8% 9% 6% 24% Credit Suisse Fellowship(*)

8% 13% 19% 64% 92% 89% 92% 78% 87% 42%

Friends Provident Stewardship(*)

39% 40% 49% 55% 75% 58% 27% 38% 20% 47%

Scottish Equitable Ethical(*)

49% 53% 59% 33% 58% 49% 19% 25% 20% 40%

Sovereign Ethical 23% 16% 15% 42% 68% 29% 16% 36% 33% 31% TSB Environmental Investor

49% 62% 37% 46% 42% 40% 36% 53% 85% 50%

UK income sector= = = = = = = = = = =Friends Provident Stewardship Inc

9% 25% 60% 63% 89% 33% 1% 4% 0% 25%

International growth sector

AberdeenProl Ethical 50% 54% 52% CIS Environ(*) 85% 68% 77% 64% 7% 61% 84% 64% City Fincl Acorn Ethical 43% 42% 36% 24% 58% 62% 0% 57% 33% 37% Clerical Medical Evergreen

0% 0% 0% 3% 0% 2% 3% 1%

Framlington Health 98% 99% 99% 99% 99% 88% 95% 86% 93% 97% Jupiter Ecology 15% 34% 47% 26% 66% 61% 27% 63% 84% 44% NPI Global Care(*) 50% 7% 63% 81% 50%

Averages by time period

All ethical funds 39% 45% 45% 45% 60% 46% 24% 42% 46% 47% All funds ex Health & Evergreen

33% 39% 44% 44% 62% 47% 20% 42% 46% 43%


32% 35% 53% 55% 76% 62% 30% 53% 58% 46%

Averages for each fund across all time periods

All ethical funds 43% All funds ex Health & Evergreen

42%


49%

4.7 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


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) Annualised figures for 36 months ended on Average 1-Jul-98 1-Jan-98 1-Jul-97 1-Jan-97 1-Jul-96 Abbey Ethical 10.0 9.4 8.7 9.0 11.4 11.4 Allchurches Amity 8.6 7.3 7.3 8.0 10.0 10.4 Credit Suisse Fellowship 10.9 10.0 9.0 10.0 12.8 12.5 Friends Provident Stewardship 10.1 9.7 9.4 10.0 10.4 11.1 Scottish Equitable Ethical 10.7 10.0 9.0 10.4 11.4 12.8 Sovereign Ethical 12.3 11.4 11.1 11.8 13.9 13.2 TSB Environmental Investor 10.1 10.0 8.7 8.7 11.8 11.4 Average UK growth ethical= 10.4= 9.7= 9.0= 9.7= 11.7= 11.8=UK Growth sector= 10.9= 10.4= 9.7= 9.7= 12.5= 12.5=

Friends Provident Stewardship Inc

9.0 8.7 8.3 8.3 10.0 9.7

UK Equity Income sector= 10.1= 9.0= 9.0= 8.7= 11.8= 12.1= Aberdeen Prolific Ethical 10.3 9.7 8.7 9.4 11.8 12.1 CIS Environ 8.7 9.0 7.6 7.3 9.7 10.0 City Financial Acorn Ethical 12.5 12.8 11.4 11.4 14.2 n/a Clerical Medical Evergreen 11.8 12.8 12.5 11.1 11.4 11.1 Framlington Health 23.5 24.6 24.6 24.9 24.2 19.1 Jupiter Ecology 10.9 11.8 10.0 10.7 11.1 11.1 NPI Global Care 10.7 10.0 9.7 9.7 12.5 11.8 Average international growth ethical=

12.6= 13.0= 12.1= 12.1= 13.6= 12.5=

Average international growth ethical (ex Evergreen & Health)=

10.6= 10.7= 9.5= 9.7= 11.8= 11.3=

International Equity Growth 12.0= 12.5= 12.1= 11.1= 12.1= 12.1

4.8 Conclusions and implications


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


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 re-

visited. 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.


(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


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.


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


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.


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.


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.


Wagner et al then looked at the increase in risk using the portfolio’s beta and R-

squared. 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.


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%.


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.


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.


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


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


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.


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 management systems, environmental

performance, environmental signalling, firm risk and firm 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


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 non-

green companies when the best financial performers were selected from the non-

green 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.


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.


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.


6 Bibliography

Antonio, Johnsen & Hutton, Expanding Socially Screened Portfolios: An Attribution Analysis of Bond Performance, Journal of Investing, Winter 1997 Blumberg, Blum & Korsvold (1997), Environmental Performance and Shareholder Value, The World Business Council for Sustainable Development Centre for Tomorrow’s Company (1997), The Inclusive Approach and Business Success Cohen, Fenn & Naimon, Environmental and Financial Performance: Are They Related?, Investor Responsibility Research Center (IRRC), April 1995 Conte, Blasi, Kruse & Jampani, Financial Returns of Public ESOP Companies: Investor Effects vs. Manager Effects, Financial Analysts Journal July/August 1996 Diltz, The Private Cost of Socially Responsible Investing, Applied Financial Economics, 1995 Vol. 5 EIRIS/BARRA (1989), The Financial Performance of Ethical Investments EIRIS/BARRA (1993 – unpublished) Edwards (1998), The Link between Company Environmental & Financial Performance, Earthscan Feldman, Soyka, Ameer, Does Improving a Firm’s Environmental Management System and Environmental Performance Result in a Higher Stock Price?, Journal of Investing Winter 1997 Guerard, Additional Evidence on the Cost of Being Socially Responsible in Investing, Journal of Investing Winter 1997 Gunthorpe, A Quantitative Analysis of the Impact of Unethical Behaviour by Publicly Traded Corporations, Journal of Business Ethics 1997 Vol. 16 Hart & Ahuja, Does it Pay to be Green? An Empirical Examination of the Relationship between Emission Reduction and Firm Performance, Business Strategy & The Environment, Vol. 5 1996 Kahn, Lekander & Leimkuhler, Just Say No? The Investment Implications of Tobacco 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


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


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.


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 All-

Share 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 Typical tracking errors14

14 Understand Financial Risk In a Day, Alex Kiam 1997


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.


Appendix 1

7.1.1 Total Return Monthly Index Values Dec 1990 - May 1999

Total

Return Charities’ Avoidance

Index

Environmental Damage Avoidance

Index

Responders Index

Ethical Balanced

Index


Index

FTSE All-Share

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


Total Return


Index


Index

Responders Index

Ethical Balanced

Index


Index

FTSE All-Share

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


Total Return


Index


Index

Responders Index

Ethical Balanced

Index


Index

FTSE All-Share

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


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]


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