Are Ethical Investment Funds Higher Risk Than Other Similar Funds?

Summary: A 'small universe' of potential shares in which an ethical investment fund manager can invest can really hold back his (or her) ability to deliver both returns and diversification. We discuss the issue here...

The nature of investing with your morals has obvious side effects. One of these is that the risks associated with ethical investment funds are higher. There are several reasons for this which shall be explained below.

Firstly, it may seem obvious to comment on, but is often overlooked that fund managers might have a very small number of potential investments to choose from. If the criteria of the fund is applied rigidly, the fund manager may only have a very small number of approved potential companies. This is known as a small universe of potential shares.

The companies available to a fund manager may be from only very selected industries. This lack of potential companies and sectors can make the returns of a fund more volatile than might otherwise be the case. These funds can also become less and less diversified.

This 'small universe' is something that happens in many walks of life. For example, many Presidents and Prime Ministers suffer from a 'lack of talent' from which to choose when it comes to filling positions in their cabinet.

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As an investor, we may wish to invest with our hearts and hope for reasonable long-term results, but in reality we are all emotional creatures. It is very easy for us as individuals to be forced to sell units in a fund because we do not like it's additional volatility.

This additional volatility can take many forms. For example, bad news published in the financial press about an industry - solar power, for example - could have quite an impact on all environmental or ethical investment funds. With underlying share prices suffering, the funds investing in these companies may all suffer.

Therefore, the combination can lead to most funds creating very similar portfolios, which generate very similar annual returns and are difficult to market because they appear to be indistinguishable from the competition.

This can make managing money very difficult for the fund manager. If every time asset prices are doing well, investors sell whilst they can - knowing or expecting there to be bad times that follow - it can become difficult to maintain the balance of a portfolio.

Though this is a different potential problem, the increasing numbers of ethical investment funds offer an investor many different choices. It is now possible to select from ethical funds aimed towards income or growth and have a range of risk profiles and asset mixes. However, if the rules are too tight on the fund manager as to what does and does not qualify for investment, this can force the fund to be very concentrated on just a few companies that fit the exact criteria required.

With such a wide range of funds, private investors will almost certainly find it difficult to make decisions that finds a fund that invests in just the right way for them - even though such an ethical fund may exist.

These funds are often now termed in relation to 'shades of green'. Those funds using a positive selection criteria and hoping to encourage better corporate behaviour are often referred to as lighter green. Ethical investment funds which exclude companies whose corporate behaviour is not approved of are usually termed as darker green.

For other pages related to similar topics, please visit:

What Is Ethical Investment?

The Ethical Investment Dilemma

What Are The Main Ethical Investment Strategies?

How And Why Does Positive Engagement Work?

What Activities Does Negative Screening Filter From Ethical Investment Funds?

What Is Positive Screening?

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