Yes, but it's an ethical oil slick you see...

In the 1920’s the Methodist church was looking at its coffers, which were decidedly bare. Their business model was good with a very loyal customer base that attended sermon every Sunday and paid a donation for the privilege. Running a church however can be an expensive business what with all those roofs to repair and big red moveable arrows to illustrate the current amount of money raised. (Presumably just in case you didn’t understand the written number after the pound sign and needed a visual guide)

Furthermore, the problem with a religion that has a doctrine so strict that dancing is deemed to be the Devils work, is that the investment options open to the church accountant amounted to blessing it, burying it in the garden and hoping for the best.

They therefore decided that they should invest in the stock market, having previously condemned it as gambling. To keep the flock happy and to stay on the right side of the moral fence they screened the investments and excluded any companies who were linked to gambling or alcohol (and dancing probably) and Ethical Funds were born.

For the next sixty years they were mainly the preserve of religious groups until the seventies when they took on a bit of a hippy image due the PAX fund, which excluded any companies involved in the Vietnam War. The mainstream investment community sneered at ethical funds much like Apple were sneered at when they came up with something called an Ipod which was supposed to rival the walkman. Oh how Sony laughed…

The inherent problem for ethical funds was that they couldn’t invest in any companies that were involved in weapons, tobacco, or gambling; or that had a unconvincing record on the environment or workers rights. Investors were still expecting a profit however, much like a groom on his stag night expecting a lady of dubious moral character armed with a tin of squirty cream, when all the best man has been given to work with is a bowl of salad and a book of psalms. Disappointed probably isn’t going to cover it.

That meant that investors who had started off with a warm glowing feeling of righteousness were a little despondent when they received their first annual statements. Statement after statement chipped away at their moral rigour until most would have invested in the Third Reich if they were guaranteed a profit.

And that’s how it would have stayed until ‘the environment’ came along. You may recall that there was quite a bit on the news about it before the recession made us all forget. To recap, the earth is heating up and we’re all going to die.

For ethical funds this was wonderful news as investors had renewed vigour for environmentally friendly products and to this day ethical funds are synonymous with environmental issues.

There are three main mechanisms which an ethical fund can employ to decide what is ethical and what isn’t. The ‘exclusion’ method is the original one and was the only real choice up until the early nineties. This just involved leaving out the nasty boys and trying to cobble together an investment strategy from the rest. The problem with this is that it didn’t guarantee that the companies in the fund were actually ‘ethical’, it just excluded industries or companies which weren’t.

As the ‘exclusion’ method was deemed to be a bit of a blunt instrument, a more elegant solution was sought. The ‘supporting’ mechanism followed in the nineties and set out to specifically invest in companies which had made a strong statement about their environmental and ethical philosophy and were seen to be demonstrating it. This was only possible because for the first time companies actually started thinking about such things and producing environmental statements and policies. This is the type of fund that most people associate with ethical investing.

This has been developed further however with the ‘engagement’ method. It picks up on the disadvantages of the first two methods in that the funds effectively end up ignoring those companies most in need of ethical influence and focussing on those that are already doing it. In effect they are preaching to the converted.

So an ‘engagement’ fund will invest in all sectors, including the bad boys, but will choose each one on the strength of their ethical commitment. That means that they will have banks and pharmaceutical and oil company stocks and suchlike but by investing in those companies, will use their shareholder power to influence board decisions and the environmental direction of the organisation.

The problem with this method is that it can lead to investments in things which to the average person probably don’t seem that ethical. Also, how far can a fund manager go when assessing a company’s ethical credential? In effect they are limited to what the company tells, them which may not always be borne out in practice. For example many funds hold shares in BP which has thousands upon thousands of pages of literature dedicated to its environmental policies, which obviously didn’t bear any relation to the actual practices on the ground. All is not lost though; maybe they could use them to mop up the oil slick?

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