Ethical investing is fast moving into the mainstream, but it still pays to listen to your head as well as your heart, writes Fiona Reddan
Despite the amount of rain that has fallen this summer, viewers of RTÉ's Future Shock programme earlier this week will not be surprised to learn that Ireland's supply of drinking water, like that of other countries around the globe, is rapidly running out.
But while this may be bad news for consumers, increased investment in the sector offers the potential for strong returns for investors who, at the same time, can play a role in developing a sustainable supply of water for future generations.
The idea of investing in a water fund stems from the concept of "ethical" or socially responsible investing (SRI), an investment philosophy that combines investors' financial objectives with their concerns about environmental, social, and governance (ESG) issues.
Today, ethical investing is moving into the mainstream, and represents up to 15 per cent of European institutional financial markets.
Moreover, despite turbulent equity market conditions, in the first half of 2008, net inflows into European renewable energy funds totalled €379 million, according to figures from Lipper Feri.
While this is down significantly on the €7.1 billion invested in such funds during the whole of 2007, it indicates that investors still see potential in the sector.
In addition, high-net-worth individuals are increasingly turning to SRI. According to a Eurosif survey, these individuals will invest more than € 1,000 billion in sustainable investments by 2012, thus increasing the proportion of their portfolios dedicated to SRI from 8 per cent to 12 per cent.
Ethical funds also appeal more to retail investors who are looking to combine investment requirements with social concerns.
"Part of the reason why ethical funds have so much mainstream popularity is the link between sustainability and investment," says Steve Falci, vice-president of sustainable investment at KBC Asset Management (KBCAM).
"Some people are looking to build a sustainable future - for example one of the first institutional investors in our water fund was the US state of Louisiana, which obviously has major issues with water supply due to the impact of hurricanes such as Katrina."
KBCAM's Dublin based eco investment division currently manages about € 2 billion across four thematic funds, "which focus on long-term solutions to our global society's most pressing environmental and sustainable challenges".
He describes three stages, or generations, of ethical investing. The first generation of funds focused on "negative screening", whereby ethical/SRI funds screened out businesses involved in alcohol, arms, tobacco, pornography, nuclear energy and animal testing.
The next generation of funds has a "positive" focus, whereby, in addition to excluding certain companies, they also select companies based on their contribution to the environment or SRI principles.
This approach began in the 1990s when the state of California began using its $300 billion (€209 billion) investment portfolio to promote ecological responsibility among corporations, greater access to housing, and human rights causes.
The final generation of funds, which have begun to emerge over the past number of years, focus on "sustainability".
"Sustainable investing is more focused on employing an integrated, forward-looking investment strategy to earn more consistent long-term returns," says Falci.
KBCAM's funds offer investors access to a range of eco strategies, including alternative energy, water and climate change. The fund manager is currently over-weight in wind energy, as it sees much potential in this sector due to favourable legislative change.
However, while investors may get a "feel-good" factor from investing in ethical or eco funds, are they actually good investments? Eco funds can offer diversification benefits to investors, with alternative energy acting as a natural hedge against rising oil prices, while water has some defensive elements.
One downside, however, of ethical funds is that they can suffer from their self-imposed limits on investment opportunities, and often invest in more small and medium-sized companies than traditional equity funds, which look to the larger players.
Moreover, many funds are excluded from investing in areas that have performed particularly well over the past year, such as oil and mining, while eco funds tend to focus on newer companies which are more growth-oriented, and so can be riskier than traditional equity funds.
Overall, results in the sector tend to be mixed. The FTSE4Good Index Series, which measures the performance of companies that meet globally recognised corporate responsibility standards, is down by about 20 per cent on the last 12 months, while its mainstream counterpart, the FTSE 100, is down by just 11 per cent.
However, in the year to the end of August 31st, KBCAM's Alternative Energy Fund returned 0.4 per cent, which compares favourably with the fund's equity benchmark, the MSCI World Total Index, which fell by 18.1 per cent, as well as the Iseq, which lost 46 per cent.
Another aspect of ethical investing investors need to be aware of is what exactly is - and isn't - included in an ethical fund. Many of the SRI funds available on the Irish market to retail investors include stocks that wouldn't look out of place in a traditional equity fund, while KBCAM includes nuclear companies in its Alternative Energy Fund - provided that less than 50 per cent of its revenues come from nuclear and that they show a commitment to renewables.
Looking ahead, investors seeking other ethical investment options apart from investing in a fund might consider carbon trading.
While, at the moment, such funds are only open to institutional or high-net-worth individuals, as the market expands, the funds might move down to retail level.
KBCAM currently has a 10 per cent allocation to carbon trading in its climate change fund, and Falci says it is a "definite growth area". Carbon funds can enable investors to diversify away from equities, and offer similar investment qualities as property.
