Tap into potential UK upside via ASI UK Ethical Equity

UK equities lagged other stock markets last year for reasons including the domestic market’s relatively low proportion of technology companies, Brexit uncertainty and the impact of Covid-19. The situation is different this year, with a lock down over the first four months of this year and a vaccination programme helping to bring Covid-19 under control. And this has been reflected by a steady rise in UK stock markets since November.

But despite a strong recovery for UK equities, some investors and analysts believe that UK equities are still relatively cheap. For example, global firms listed in the UK are trading at price-to-earnings discounts relative to foreign competitors.

And UK equities could have further to go. Mergers and acquisitions are at record levels, at least among non-standard UK stock market participants, according to Richard Colwell, head of UK equities at asset manager Columbia Threadneedle Investments, who expects more bids to follow. Institutional investors had divested of UK equities over the past few years but are now starting to allocate to this market again. And UK companies have been reporting strong trading.

Domestic economic improvements include a higher level of personal savings than before the outbreak of coronavirus last year and the prospects of people being able to spend them as more areas of the economy, such as hospitality, open up. The International Monetary Fund predicts that UK gross domestic product (GDP) will rise 5.3 per cent this year – faster than for many advanced economies.

If you are persuaded that the UK recovery can continue recovering it could be worth getting some exposure to mid-sized or smaller companies, which typically have greater exposure to the domestic economy. A good way to do this could be ASI UK Ethical Equity Fund (GB0004333059) which typically has a mid-cap bias. As of the end of April, about half of its assets were in companies of this size and nearly a third in smaller companies, according to data provider Morningstar. And 22.6 per cent were in consumer discretionary companies and 17.3 per cent in financials – areas that could benefit from economic improvement.

Since 2004, the fund has been managed by Lesley Duncan, deputy head of UK equities at Aberdeen Standard Investments. Rebecca Maclean has been co-manager since 2018, and they are supported by 15 Aberdeen Standard Investments UK equity analysts and this company’s smaller companies team of eight.

The fund's managers select stocks using Aberdeen Standard Investments' proprietary screening tool which looks for quality, growth, momentum and value. They then look for companies whose upside potential is not priced into their shares.

ASI UK Ethical Equity could also appeal to growth investors who want to invest via an ethical approach. Its managers use negative criteria to avoid investing in companies in certain areas such as those that derive revenue from animal testing, weaponry, pornography and gambling. And they aim to include companies they think help to preserve the environment, or improve the quality and safety of human life. When assessing whether business activities make a positive contribution, Duncan and her team refer to the UN Global Compact to define the areas in which they seek companies with positive business practices and services. These include human and labour rights, environmental safeguards, and combating bribery and corruption.

“Our ethical investment approach combines fundamental, bottom-up stock selection with informed views on how individual companies impact the wider society and environment,” says Duncan. “From a financial perspective, we aim to identify positive drivers of change at the company level that the rest of the market has yet to price in and exploit this ahead of the market view coming into alignment with us. Systematic consideration of ethical issues is firmly integrated into this process through proprietary indicators that capture the ethical profile of companies within the investment universe. Through strict adherence to our investor-led ethical criteria, companies are then classified as acceptable or preferred. The criteria that determines this classification is regularly reviewed through investor surveys and consultations, to ensure that our ethical policy remains relevant and reflective of our investors’ views.”

A problem with ethical funds is that their ethics may not match yours. But investors in this fund get an opportunity to influence what ethical criteria it follows via regular surveys.

Despite the strict ethical criteria, the fund has a good record of outperforming conventional UK equity funds and the FTSE All-Share index, in keeping with its aim of delivering at least the return of the FTSE All-Share plus 2 per cent a year over rolling five-year periods, before charges.

The bias to medium-sized companies means that the fund can be volatile so on a year to year basis it can swing from making very strong returns to steep negative returns.

There is no guarantee that economic improvements will continue as it could take some time to get Covid-19 more under control. The UK’s departure from the European Union might have a negative effect on the domestic economy. And UK indices have already risen a good deal so are not at their cheapest, and might fall back for the reasons set out above.

The fund’s managers also don’t always get their ethical selection right. For example, the fund’s largest holding at the end of June 2020 was online retailer Boohoo (BOO), whose share price plunged after allegations of poor worker practices in its UK supply chain.

However, if a holding doesn't continue to meet ASI UK Ethical Equity’s ethical criteria its managers sell. They disposed of Boohoo soon after the problems emerged and they had investigated them. Duncan said: “We view Boohoo’s response [to the allegations] as inadequate in scope, timeliness and gravity. We strive to use our influence as significant investors to achieve progress. In instances where our standards have not been met, divestment is both appropriate as responsible stewards of our clients’ capital and aligned to our goal of investing for better outcomes.”

Despite periods of volatility, the fund has generated good long-term returns and could continue to. Even if overall UK economic growth and broad market indices go down, the selection of companies the fund holds will not necessarily do badly. And its screening process includes an assessment of value.

So if you’re a long-term growth investor wanting to buy into a potential UK recovery, and or prefer to invest via an ethical stance, ASI UK Ethical Equity still looks like a good option. Buy. LW