Midweek Money: Money and morality

Does anyone really want to buy shares in a company that destroys rainforests, makes landmines, or helps prop up an undemocratic regime? Opinion polls suggest not. Most of us would like to see our investments run on ethical and environmental principles.

Far fewer of us - barely a fifth - realise that there is an ethical investment option, with a wide enough range of products currently available to cover most of our requirements. These products range from PEP-able unit and investment trusts, through personal pensions, to endowment savings plans that can be used to pay off a mortgage.

The growth of the ethical sector has also been rapid, with more than pounds 2.2bn under management in unit and investment trusts alone. The largest of these funds, Friends Provident's Stewardship unit trust, controls assets worth more than pounds 670m. Charities and a growing number of local authority and trade union pension schemes use ethical or environmental criteria to "screen" potential investments. Charities alone currently invest more than pounds 10bn in this way.

Tessa Tennant, head of research at NPI's Global Care Fund, says: "Ethical investment is no longer seen as cranky or bad for your pocket. It has entered the mainstream."

So how do ethical funds differ from the non-ethical? They use negative and positive screens to avoid and select certain areas of investment. For instance, the Stewardship fund avoids animal testing and the production and sale of alcohol, and applies no fewer than nine negative screens.

But critics argue that using negative criteria achieves little in terms of changing the practice of those companies whose shares are not bought by ethical fund-managers. Much here depends on the use of positive screening, and a new style of pro-active shareholding, with fund managers trying to bring about changes in policy among the company managements they deal with.

While some funds, such as Scottish Equitable's Ethical unit trust, have no positive screening, longer-established ones like the Stewardship or NPI's Global Care unit trust, promote change in this way.

If you want not just to avoid certain business areas but also to support others, then the positive screens used by a fund may be as important as the negative ones when you make a choice between them. Look also at the types of contact maintained between your ethical fund manager and the companies they invest in. As an example, Aberdeen Prolific's Ethical unit trust uses eight negative screens, but only two positive ones, and does not talk to company management on ethical issues. By comparison, the Stewardship fund has eight positive screens, carries out its own ethical research, talks to companies on ethical issues and makes on-site visits.

This shows how much these funds can differ, but the use of negative and positive criteria does give them one feature in common: they hold a higher percentage of shares in small to medium-sized companies, and a smaller percentage in large companies, than their non-ethical equivalents.

Understanding how this can effect fund performance is important if you decide to choose an ethical investment. Shares in small companies are inherently more volatile than those of large ones.

For instance, about 70 per cent of the daily value of all shares traded on the London Stock Exchange are in the 100 largest firms. Yet because of negative screening, most ethical funds will invest in no more than 20 or 30 of these. This means that if you invest in an ethical fund, you should be doing so over at least the medium term - say, five years - and not expect short-term gains. This is not just because of the size of the companies, but also their type of business. Many are providers of goods or services in areas ranging from protection of the environment to public transport, and from energy efficiency to recycling consumer waste.

Richard Singleton, of Friends Provident, argues: "Very often we are helping to develop the industries of the future. Take pollution. There is a long- term benefit both in environmental terms and for shareholders if a company can anticipate future regulatory changes and build these into current operations. Today we are seeing industries having to clear up after themselves. Surely it would have been less expensive for them to have avoided this in the first place."