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L&G UK Ethical Trust has its strong points, but they come at a cost that may be unpalatable to some

April 2008

L&G Ethical Trust is an ethical tracker, and there aren't many of those about. Ideally, such a fund would provide investors with low-cost exposure to a basket of ethical companies from its benchmark. After all, the point of putting your money in a tracker is largely to save on fees. Unfortunately, the fund does not entirely live up to those expectations.

It tracks a custom index created by screening the FTSE 350 index on a set of ethical criteria that was determined by L&G's Head of Corporate Governance, Andy Banks, in 1999. Banks and his team conducted research into what the man on the street deemed as ethically unacceptable. These factors were then passed to ethical research firm EIRIS to determine which FTSE stocks fulfilled that set of criteria. EIRIS monitors the list on an ongoing basis and informs L&G of changes to stock eligibility on a monthly basis.

This results in a portfolio that, relative to other ethical offerings, holds a higher proportion of giant and large cap stocks. As a result it is heavily underweight more unpredictable small and micro cap names, which helps reduce the fund's overall volatility. This is a point in the fund's favour, as low large-cap exposure and high levels of volatility make many ethical funds unsuitable as core holdings.

So far so good. However, the ethical criteria that led to that portfolio might surprise investors seeking a stringently screened offering. For example, it can hold companies that operate in up to four unsavoury countries, but not in five. The distinction appears to be without ethical justification, but it permits the fund to invest across a broader group of securities. Take Rio Tinto for example: The miner is not included in the fund, but the fund's custom-screened index includes others, such as BHP Billiton and Xstrata. The reason the latter are more concentrated, and unlike Rio, operate in fewer than five blacklisted countries (countries with poor human rights records).

As befits any passively managed fund worth its salt, manager Ian Clarke employs strategies to keep transaction costs down. For example, he cross trades internally wherever possible to avoid brokerage costs. This is important given that companies can move in or drop out of the benchmark on a monthly basis. However, in terms of its ongoing costs excluding trading, we believe the fund is disappointing. L&G charges investors a TER of 1 per cent per year to run this offering. We appreciate that there will be a fee paid to EIRIS for the social screening, and the fund is cheap by ethical-fund standards, but at the end of the day, it's expensive for a fund that requires no active management. By comparison, FTSE All-Share tracker Fidelity Moneybuilder UK Index fund charges just 0.28 per cent per annum in TER. That fund is the cheapest index offering in the UK, and is not ethically screened, but it means that investors are essentially paying a 72 basis point per annum premium here for this fund's ethical screens.

The fund has its good points: It offers more core-like equity exposure than most ethical offerings; it is the cheapest retail ethical fund, as it should be given that it's passively managed; and it has performed solidly relative to other UK-focussed ethical offerings, returning 1 per cent per annum more than its peers over the last 5 years. Nevertheless the latter partly reflects a strong 2007 campaign, where its large-cap bias and willingness to own mining companies helped it substantially. But the question is whether its criteria are strict enough to merit investments from those truly concerned about ethics. For many, the answer may be no. Further, although the fund is cheap for an ethical fund, we believe it should be less costly.

Strategy
The fund aims to track the performance of companies contained within the FTSE 350 (ex IT) whose business conforms to a range of ethical and environmental guidelines. All such companies will be held with weightings generally proportionate to their market capitalization, so that the fund is passively managed to track the group of stocks that pass the fund's screens. The criteria for exclusion were developed by L&G following market research of customer preferences in 1999, with the process overseen and developed by LGIM Corporate Governance Manager, Andy Banks. Based on these criteria (listed below) EIRIS, the independent ethical research organization, analyze all constituents within the FTSE 350 Index and filter out unacceptable securities. Companies have been excluded if they are substantially involved in or cause: Animal testing, Countries with poor human rights records, Gambling, Health & Safety breaches, Intensive farming, Major arms exporter to oppressive regimes, Nuclear Power, Pornography, Processing, use or sale of tropical hardwood, Production of ozone depleting chemicals, Production or sale of tobacco, Production or sale of weapons systems, Provision of nuclear weapons and Water pollution.

Management
Fund Manager Ian Clarke is highly experienced and is responsible for the team managing the UK and Asia-Pacific Markets equity index funds. Clarke joined L&G in June 1971 with a degree in Mathematics from Oxford University. He transferred to LGIM in 1973, and qualified as a Fellow of the Institute of Actuaries in 1976. His career in UK equities began in 1973 where he initially worked in the actively managed UK Equity team with responsibility for investment analysis of various UK market sector. He subsequently managed a number of UK equity funds, transferring to Index Funds in 1996.


This piece was provided courtesy of Morningstar, an Independent Investment Research Firm.




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