Regardless of how they interpret their mandate, the most pronounced bias among UK ethical equity funds is evident in their market-cap exposures. As is true elsewher
e in the world, ethical screens in the UK tend to weed out larger companies disproportionately, resulting in a distinct small- and mid-cap bias to most funds in the group. To put some firm numbers around the issue, ethical funds in the IMA's UK All Companies sector have a median exposure of 45% of equities to large-caps, compared to 64% for the median offering in the broader group. Conversely, their median exposure to mid-caps is 27% and to small caps is 25%, compared to 24% and 10% for the median UK All Companies offering. Most also tend to be underweight in areas such as mining and energy, as companies in these sectors often fail social and environmental screens.
The result is that--relative to the broader UK All Companies sector--ethical funds tend to perform well when small- and mid-caps run and mining and energy are weak, and to underperform in the opposite circumstance. In 2007, for example, large-caps led the market and mining and energy issues were especially strong. As a result, most ethical offerings underperformed their respective Morningstar categories and the broader UK All Companies sector: The median fund in the ethical subgroup posted a loss of 4.3% for the year, compared with a gain of 2.6% for the median All Companies offering.
From a risk perspective, ethical funds as a group have standard deviations that are in line with the UK All Companies median over the past three- and five years. However, this may be misleading as it reflects a broad period of strength for small- and mid-caps. Whilst the funds' tendency to invest less in cyclical areas could help tamp down economic risk a bit, ultimately, their exposure to the lower rungs of the market-cap ladder and inability to diversify as broadly across economic sectors as unscreened competitors exposes them to a somewhat higher degree of fundamental risk in our view.
If you are determined to use an ethical fund despite their limitations, we believe F&C Stewardship Growth is a reasonable choice. Investors should be aware that it suffers from all of the above-mentioned issues--especially the mid-and small-cap risk--but it features an experienced management team led by Ted Scott and a screening process that is robust and covers a variety of factors. However, our overriding concern remains that many of these funds, including the F&C offering, have benefitted from a small- and mid-cap tailwind that is likely not sustainable going forward. Indeed, although most appear to have performed well versus the broader UK All Companies sector over the past five years, if one controls for market-cap exposure by using the narrower, market-cap based Morningstar categories, just three of the 20 offerings with five-year records beat their typical peers, likely reflecting the limitations imposed by their investment screens. In short, be prepared for higher risk and potentially lower returns from these funds in the future, and ideally, use them as part of a broader portfolio to help offset their biases.
A version of this article previously appeared in Investment Adviser, Financial Times Ltd.
