Why now is a time for defensive investing

The week before last we told you that we thought the volatility that kicked off on 27 February was not a one-off, but the beginning of something big. Last week, we repeated ourselves. And this week we are doing so again. The S&P has fallen 6.4% since 26 February. The FTSE 100 has fallen 6.2%. Those are big falls in a very short space of time. They may not count as a crash quite yet, but I think we can safely say that they are the most visible aspects of what surely counts as a crisis, and a fascinating one at that.

Why so fascinating? Because no one has the faintest idea how it might unfold. As Antony Hilton points out, this is the "first truly modern financial crisis". Over the past five years, institutions have lent more and more money out with less and less concern about whether it will be paid back: the credit derivatives invented in the "laboratories of the financial world" have allowed them to sell on the risk of default in a "giant game of pass the parcel". The result has been that the "natural ceiling on lending" has failed to kick in. "Everything has been in thrall to, and distorted by, the power of cheap money."

We haven't been in this situation before, so who's to know what might happen next? At MoneyWeek, we can't be sure, but we guess it will be something bad. And to us, that means that now is a time for defensive investing. Next week, we will look at exactly how best one can do this, but for now I'd like to point to one thing that probably isn't very defensive: buying into ethical funds.

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The green bandwagon has gathered momentum at the most astonishing speed (witness the knots our would-be political leaders are tying themselves up in in their efforts to out-compost each other). A decade ago you could have counted the number of ethical funds on your fingers, now you can choose from 90. You can go dark green or light green, demand positive or negative criteria and demand a moral, or just an environmental, focus (for more on ethical funds, see: How to invest with a clean conscience). With this rise in choice appears to have come performance: over three years the ethical sector has done better than the non-ethical.

So what's the problem? The fact that the sector is biased towards technology, new energy, carbon trading and small caps (most blue chips will never make the goodness grade), which suggests the good performance can't be sustained. Money is pouring into alternative energy right now, but as the credit crunch hits, and the US moves into recession, is that supply of funds going to keep flowing? I doubt it. As for all the firms that are pouring money into green initiatives to get themselves on to ethical buy lists, are they going to keep it up when profits start to fall? Again, I doubt it. I suspect these funds are about to find that the last three years are in no way representative of the future.

Personally, I'm tempted to ignore the lot of them and improve the world by committing regular but random acts of kindness and never buying a Porsche Cayenne instead. But for those of you who would like to put your money where the world's politicians are putting their mouths, we have a look at the better funds here.