How Green Are The Ethical Funds?

By Adrian Herbert

Eco Investor, June 2006

Investors increasingly want to ensure their savings are not invested in activities of which they disapprove. Much of this investment flows into ethical or socially responsible managed funds and the sector’s total of funds under management has more than doubled over the past three years to about $5 billion. Environmental matters are the primary concerns for many of the investors in these funds, and this raises the question: just how green are ethical investment funds?

The answer is clearly nowhere near as green as investors might believe.

The reasons for this start with the funds’ origins.

Ethical investing existed as early as the 1920s mainly sponsored by church organisations which avoided investing in areas such as alcohol, tobacco and gambling. In the 1970s, opposing the Apartheid regime in South Africa became a key target of funds internationally and attracted wider interest to this form of investment. Secular ethical investment funds first gained prominence in Australia in the 1980s. These funds were focused on investing in businesses which followed good social principles. This ruled out investment in companies which caused serious environmental damage but environmental issues were not primary considerations.

Over the past two decades investors’ concerns have widened and environmental issues have become the main concerns for many investors. As a result, the focus of funds has widened with “sustainability” now being a key word for some but few have a primary focus on protecting the environment.

Across the entire sector, managers describe their products as ranging from “light green” to “deep green” but this is not a direct indication of their environmental credentials, rather of levels of social responsibility.

Phillip Gray of research house Morningstar says “Ethical investing comes in many shades ... from our perspective, we would want investors to know and feel comfortable with what they’re investing in.”

Most of the funds are clearly at the light green end of the spectrum.

This is significant. Many of these funds invest in contentious areas like mining and some are exposed to uranium mining, which is controversial.

We picked a number of retail funds which invest in Australian shares for closer examination.

The funds examined were: Hunter Hall Australian Value Trust, Australian Ethical Investment Balanced Trust, Challenger Socially Responsive Fund, AMP Capital Sustainable Australian Share Fund and BT Australian Sustainability Share Fund.

The specific ethical or social responsibility objectives of these funds depend on their charters, but the methods of selecting investments are generally similar. They start with negative screening - that is screening out activities pre-defined as being undesirable. Some also employ positive screening - that is they screen potential investments to include activities pre-defined as favourable.

Funds which employ negative screening only are described within the sector as “light green” while those that employ positive screening are “dark green”.

Negative screening is generally used to rate companies on ethics and social responsibility before financial factors are taken into account. Some managers, however, select potential investments on financial factors first and then screen them for ethics and social responsibility.

Ethics is considered to include factors such as working conditions and business practices. Social responsibility includes awide range of concerns such as not being involved with armaments, tobacco, alcohol or activities which are harmful to the environment.

Negative screening appears to be tuned to the net effects of a company’s activities. Consequently, a company which is mainly involved in ecologically benign activities but also has some involvement in undesirable activities may not be excluded.

BHP Billiton is a prime example. As a result of the takeover of Western Mining, BHP Billiton now owns the Olympic Dam uranium mine in South Australia, one of the world’s largest producers of uranium. Despite this, a number of ethical or socially responsible funds have retained holdings in BHP Billiton, and for some it represents a large proportion of their portfolio.

These include the AMP Capital Sustainable Australian Share Fund, BT Australian Sustainability Share Fund, Challenger Socially Responsive Investment Fund and the Glebe Large Cap Equities Trust. (This fund was not examined as the manager, Glebe Asset Management - owned by the Anglican Church of Sydney - is closing its business and is in the process of terminating its funds and returning cash to investors.)

Morningstar’s Phillip Gray says “We would want investors to be aware of situations which they might not necessarily expect. I think the ordinary person on the street, if asked what they would consider to be an “ethical” fund, for example, would not necessarily expect to see BHP Billiton ...”

Some fund managers have stated their continuing opposition to mining uranium or using it for power generation. But the organisation which represents socially responsible and ethical funds managers, the Ethical Investment Association (EIA), appears to be sitting on the fence.

Responding to the Federal Government’s decision to give the green light to uranium sales to China, the EIA stated “In a short space of time Australia’s staunch anti-nuclear stance has been softening. In addition to the emergence of recent trade opportunities, supporters have cited climate change imperatives to justify the inclusion of nuclear energy as a low carbon component of Australia’s energy mix. In the face of this change, opponents stand firm claiming that storage, disposal and national security are unresolved issues ...”

But even in funds where negative screening is tuned to eliminate investment in ecologically damaging sectors - mining being the obvious example - it will not necessarily boost investment in activities which have a positive effect on the environment. Rather, it may simply result in increasing exposure to sectors which can be regarded as having a neutral effect - financial services and engineering for example.

Positive screening is required to ensure that funds predominantly invest in businesses which provide environmental positives as opposed to simply avoiding those that harm it. Positive screening was found to be used by a minority of the funds examined.

Richard Whan, an investment adviser with Victorian specialist firm Ethical Investment Services, says investors who seek advice from his firm place corporate governance, sustainability and preserving the environment at the top of their list of concerns. Many have strong views on sectors which they want to avoid and to which they wish to gain exposure. Uranium mining tops the list of environmentally undesirable activities.

He says few of the ethical and socially responsible managed funds meet the criteria of these investors but considers Australian Ethical Investment to be an environmentally sensitive fund manager, and awaits a proposed new “dark green” fund from Hunter Hall with interest.

Australian Ethical Investment executive director James Thier says the manager operates both negative and positive screening and has been confirmed as a “dark green” manager by independent research house Lonsec.

Australian Ethical is committed to ecologically sustainable and ethical investment and considers that to exclude uranium mining, he says.

Mr Thier says the Balanced Trust has invested in the unlisted Australian Government supported CVC Renewable Energy Equity Fund - which invests in emerging renewable energy companies - and has direct investments in companies such as energy major Origin Energy, which has extensive natural gas reserves and is Australia’s largest producer of coal seam gas; methane gas producer Energy Developments; renewable energy company Novera; and bio-degradable packaging company Pro-Pac.

The Balanced Trust also invests in promising new technologies which may promote ecological sustainability. These include Geodynamics, which is working on clean production of electricity by producing steam by injecting water into hot rocks deep underground, and Ceramic Fuel Cells which is developing small scale, highly energy efficient, low pollution power generation units.

Waste management and recycling are also areas in which the Balanced Trust has investments with shareholdings in companies such as Baxter Group of Melbourne, international metals recycler Sims Group and Waste Management which has operations in Victoria, South Australia, NSW, and Queensland. Waste Management recently accepted a takeover proposal from Transpacific Industries which Mr Thier said may require a reassessment of this investment. Aside from waste management, Transpacific Industries is involved in importing, selling and servicing heavy trucks.

Australian Ethical Investments also manages the Ethical Equities Fund and the Large Companies Share Fund, both of which have a significant number of listed companies involved in environmentally positive activities. In fact these could be seen to be the greenest of the Australian ethical funds.

All three AEI funds also have an allocation to international ethical equities. AEI also supports some early stage ventures in environmentally positive areas through private equity investments and direct loans.

Australian Ethical Investment’s portfolios for each of its funds can be viewed on its website: www.austethical.com.au.

AMP Capital Investors says its AMP Sustainable Future Australian Share Fund seeks out industries of the future - companies which are providing solutions to social and environmental challenges, for example in healthcare, renewable energy and education. The fund also invests in leaders within traditional sectors that exhibit high levels of corporate social responsibility.

The fund’s top ten investments are: BHP Billiton (10.9 per cent), ANZ Banking (6.9 per cent), Westpac Banking (5.5 per cent), Woodside Petroleum (4.0 per cent), Commonwealth Bank (4.0 per cent), QBE Insurance (3.9 per cent), Macquarie Bank (3.6 per cent), National Australia Bank (3.3 per cent), CSL Limited (2.7 per cent), St George Bank (2.6 per cent).

Challenger Financial Services says its Challenger Socially Responsive Investment Fund uses both negative and positive screens. Potential investments are first screened to rule out those that do not meet socially responsive investing principles. Companies that pass are then ranked via detailed analysis.

The top five investments in the Challenger Socially Responsive Investment Fund are: BHP Billiton, Brambles Industries, Commonwealth Bank, Mayne Pharma and Mirvac Group.

Sector exposures are: financials 39 per cent, consumer discretionary 12 per cent, industrials 11 per cent, materials 9 per cent, health care 7 per cent, property trusts 6 per cent, consumer staples 4 per cent, energy 3 per cent, utilities 2 per cent.

The Hunter Hall Australian Value Trust (AVT) follows a mandate which excludes investments harmful to people, animals or the environment.

Chief executive David Buckland says all of the Hunter Hall trusts use the same negative screening procedure. This rules out investment in companies that profit from armaments, tobacco, gambling, cruelty to animals, destruction of the environment and uranium mining.

But he says the manager does not specifically avoid investing in businesses engaged in mining and has always been open about that.

Hunter Hall states on its website “We are of the view that mining does not necessarily cause permanent damage to the environment, provided that due attention is paid to site remediation, control of contamination, worker safety and the welfare of any nearby population.”

The AVT portfolio is focused on small and medium sized manufacturing, service and distribution businesses.

The current top ten investments are: RCR Tomlinson, engineering services (9.2 per cent); Ausdrill, drilling (8.5 per cent); PCH Group, construction equipment hire (7.4 per cent); Structural Systems, engineering (5.9 per cent); Macmahon Holdings, contracting (5.4 per cent); Lighting Corporation, lighting (4.9 per cent); Customers Limited, electronic transaction services (4.2 per cent); Promentum, printing (4.2 per cent); Legend Corporation, semiconductors (4.0 per cent); Colorpak, packaging (2.7 per cent).

Mr Buckland says interest in specifically environmentally positive investing is growing and Hunter Hall plans to meet this with a new negative and positively screened Global Deep Green Trust which he hopes will be on offer by September.

He says the new trust will invest in Australia and New Zealand but will be given a world focus as opportunities for environmentally favourable investments are much greater overseas, particularly in Europe and Japan where environmentally focused businesses are more mature and governments provide more support for initiatives such as alternative forms of power generation.

Further information regarding the AVT portfolio is available in the annual report accessible via the manager’s website: www.hunterhall.com.au.

The BT Australian Sustainability Share Fund applies a triple bottom line best of sector approach to select companies from the ASX 200 Leaders Index, says BT Funds Management’s Manager Sustainability Investments, Duncan Hodnett.

The fund’s selection criteria was developed in conjunction with the Monash Centre for Environmental Management.

Mr Hodnett says potential investee companies are first assessed on environmental and social factors and then on financial considerations to identify best in sector performers in all three categories. He says this selection method is quite different to those used by ethical funds and produces a portfolio slanted toward companies which contribute positively toward environmental sustainability.

The portfolio includes resources sector companies but Mr Hodnett says these have all recorded sectorleading environmental performance.

BT Funds Management previously also managed one fund which was slanted toward ecologically minded investors, the Australian Eco-Share Fund. This was terminated for retail investors earlier this year with most investors accepting an option to transfer to the BT Australian Sustainability Share Fund. It is, however, being continued for one major institutional investor.

The top ten investments in the BT Australian Sustainability Share Fund portfolio are: ANZ Banking Group, Macquarie Communications Infrastructure Group, QBE Insurance Group, Macquarie Infrastructure Group, Macquarie Countrywide Trust, Metcash Trading Ltd, Oil Search Ltd, Woodside Petroleum, Mayne Pharma, Henderson Group PLC.

Further information regarding the BT Australian Sustainability Share Fund, including a full list of investments, can be found on the manager’s website: www.btfunds.com.au.

While ethical and socially responsible funds clearly cannot be regarded as environmentally positive funds, they do offer environmentally minded investors opportunities to avoid many environmentally negative areas. Their financial success also suggests that there is potential for funds with a stronger environmental bias.

Morningstar’s Gray points out: “Notwithstanding the arguments both sides like to trot out, there are currently no statistically significant differences between the three and five-year returns produced by the small group of retail ethical share funds and the averages for the same periods for the (admittedly much larger) group of 311 ‘non-ethical’ retail share funds. There is only 18 basis points difference between the two groups’ five year returns, for example.”

Gray says the slight under-performance of ethical compared to ‘non-ethical’ funds over the past year may be attributable to the ethical funds having lower exposures to resources stocks than many “non-ethical” funds.

Clearly a fund which is positively screened toward environmentally positive investments will have to achieve a financial performance at least as good as the ethical and socially responsible funds. It will be interesting to see whether a fund manager will take on this challenge with a new fund or by increasing the environmental credentials of an existing fund.

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