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Demand for ethical funds has soared in recent years as investors look to put their money to work in ways that make them feel good.

In the UK, sales of ethical funds have tripled in 2020, according to the Investment Association. The amount invested in ethical funds jumped to £10bn for the year from £3.2bn in 2019. Almost 20 per cent of all money invested in December 2020 flowed into ethical investment funds.

Investors interested in adding more ESG (environmental, social, and governance) investments to their Isa portfolios can choose from hundreds of options as the sector has grown in popularity. The government is also fuelling the trend, recently announcing it would launch green bonds, to be offered to retail investors through National Savings & Investments, the state-backed savings scheme.

But the reality of investing ethically remains complex and the burden largely falls to investors to determine what represents an ethical investment for them, experts say.

“Those who wish to invest ethically do need to put a bit more elbow grease into picking their funds,” says Laith Khalaf, an analyst at investment brokerage AJ Bell. “Not only do they need to pick a quality fund manager, they also need to make sure the fund measures up to their own ethical criteria.”

Some evidence suggests the trend towards ethical investing is still a young one for Isas. Though the average amount of Isa funds invested in socially responsible funds on Interactive Investor, an investment platform, has doubled in the past three years, it still accounts for a small fraction of Isa money managed on the platform. Just 3 per cent of total fund assets in the UK are managed under “responsible” funds, according to the IA.

How ethical funds are defined is still an issue for debate within asset management. Some funds operate by excluding certain “sin” stocks such as pure coal or tobacco. Other funds focus on themes such as renewable energy or measurable positive social impacts, while some just track indices but adjust their weighting away from less ethical stocks. It is up to investors to look under the hood of their investments, and determine which approaches they are most comfortable with.

Investors looking to build diverse portfolios have options, but there are some trade-offs, advisers say, such as high dividend payments.

“There are enough ethical funds available to be able to construct a well-balanced portfolio,” says Myron Jobson, personal finance campaigner at Interactive Investor. “However, there are a few gaps, most notably in the income space . . . Many of the big dividend payers [such as oil companies] are difficult to label ‘ethical’.”

And investors must also consider their priorities. Why exactly do you want your money to grow in ethical investment vehicles, as opposed to more traditional stocks and shares? “The first critical question to ask yourself is, are you investing for your legacy because you’re trying to make the world a better place, and you don’t mind underperformance,” says Dana D’Auria, co-chief investment officer at Envestnet, a technology and service provider for financial advisers. “Or are you investing because you believe these companies outperform over time?”

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Lots of factors can be brought into play to determine whether a stock can be considered ethical, and investors must decide which are most important to them. Three-fifths of clients on Interactive Investor say environmental impact is the criterion they consider most important for ESG investments.

“The S and G are equally important, depending on your moral values,” says Jobson. “Don’t like the idea of investing in companies involved in animal testing and armament production? There are funds that strip out such organisations from their investment universe.”

Investors should not “let the perfect be the enemy of the good”, Khalaf says. “It’s probably worth approaching the process [of determining ethical investing red lines] with a willingness to compromise.”

Analysts at Interactive Investor point to the BMO Responsible UK Income fund for income investors, which targets long-term income and growth by investing mainly in UK shares and yields around 3.7 per cent.

Investors looking to get ethical exposure while keeping costs down might consider the growing number of exchange traded funds with ethical exposure, though advisers note that these vehicles often have less stringent screening for their underlying investments than actively managed funds.

“ETFs definitely have an advantage in allowing investors to participate in a theme or sector indiscriminately. However, this is more problematic when applied to ESG themes which tend to be quite nuanced, often highly personal to the investor and sometimes more difficult to define in a uniform fashion,” says Isabel Kwok, investment manager at JM Finn.

To filter out funds that are simply jumping on the trend without recasting their investments, Kwok says: “I look for managers who have been investing in the area before it became popular, especially those who are well connected on these issues and can demonstrate a passion for the sector.”

“Beware of greenwashing, where companies just clean themselves up on the surface to blend in with the ESG craze,” says Dan Lane, a senior analyst at low-fee platform Freetrade. “When it comes to what your personal ethics are, you’ll have to be a bit more discerning in the broader market.”

The most widely held ESG-focused ETFs on the platform include iShares Global Clean Energy ETF, L&G Battery Value-Chain ETF and Renewables Infrastructure Group.

“ESG isn’t a fringe concept any more,” says Lane. Its strong performance has helped mainstream ethical investing. “The spring back in highly rated ESG firms over 2020 showed they weren’t idealists, they were actually just good companies.”

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