In Search of Saintly Stock Picks

by Jon Entine

"Ethical" mutual funds have a devilish time keeping pure

We won’t invest in companies that sell tobacco products, or utility and mining firms that use nuclear power," explains David Shuttleworth, vice-president, marketing and sales, for the Ethical Funds, Canada’s largest family of "green" mutual funds. Shuttleworth invests only in companies that can pass through ethical "screens" that award high marks for harmonious labour relations and generous charitable giving, and rejects firms engaged in manufacturing tobacco products and nuclear power.

According to the Toronto-based Social Investment Organization, assets in Canadian ethical funds top $1.2 billion. The oldest Canadian fund, started in 1986 by Vancouver City Savings Credit Union, has $410 million in assets. Today it’s one of some 20 ethical funds designed to tap affluent boomers seeking guilt-free investments.

But funds can’t easily avoid, say, natural resource stocks, which are rejected by many U.S. funds on environmental grounds. "You just can’t do that in Canada," says an almost apologetic Michael Jantzi, who heads a firm that researches the ethical track records of publicly traded companies. "Resource companies make up more than 40% of the Toronto Stock Exchange. If you eliminate these sectors, you don’t have diversification. And if your fund isn’t diversified, its performance is volatile and you will drive out investors." Jantzi’s solution? "We screen for ‘best in sector.’" That is, he sometimes has to settle for the least-bad actors.

No matter how well intentioned, though, a strategy of investing in "good" companies makes sense only if you suspend some rules of logic. For instance, ethical funds typically favour stocks in the financial-services industry, which is regarded as non-polluting. But it’s the rare bank that doesn’t have loans to natural-resource firms and defence contractors on its books. Or take "sin" stocks: Naturally Shuttleworth avoids cigarette manufacturers. But what about a firm that makes packaging for them? "Well, yes," he says, "if less than 20% of its business is making tobacco packaging, I guess we would invest." Why 20%? "Well, that’s just the cutoff point we set."

The information on which such decisions are made is sometimes suspect. Researchers who advise funds on stock selection scan data banks for environmental irregularities, but for the most part they depend on information provided by the companies under scrutiny. That’s how researchers who gave The Body Shop International PLC (BSI) high ratings chronically failed to detect that the firm’s stated goals and achievements didn’t always jibe with actual practice. "We used public-domain articles and questionnaires," says senior analyst Simon Billenness at Boston’s Franklin Research, which gave BSI its highest ratings, before dumping its 46,000 shares last year. "We learned a hard lesson: This is not a science but an art."

The practice of ethical investing is at its most artistic in the devising of screens that are supposed to distinguish "ethical" firms from others. Says William Martello, assistant professor of policy and environment at the University of Calgary: "Funds make subjective distinctions between defensive weapons and offensive weapons. It doesn’t make sense. These are idiosyncratic ideological filters, not ethical screens."

How do the ethical funds perform for investors? Recent studies suggest that the funds track the market. There are some dogs, but also some stars, such as the U.S. growth fund Parnassus, which has an environmental tilt, and boasts a 20% five-year return.

The more relevant question is: Are the funds helping to make the world a better place? Jantzi thinks so. "Companies respond to negative publicity," he says. "If we help publicize environmental or ethical inconsistencies, it affects corporate behaviour."

But John Bishop, professor of business ethics at Trent University in Peterborough, Ont., disagrees: "Ethical funds might make investors feel good. But ethical investing accounts for less than 1% of the market. The impact is negligible, like taking a bucket of water out of the shallow end of a swimming pool and emptying it into the deep end."

Tempering idealism with pragmatism, Shuttleworth pleas for patience. "We have our ethical guidelines," he says, but funds have to produce decent returns or even ethical investors will take flight. "The bottom line is still money," Shuttleworth says. "We have to make a profit for our investors."