Looking behind the definitions as clients demand grows

Looking behind the definitions as clients demand grows

So, what is the difference between environmental, social and governance (ESG) investing, socially responsible investing and impact investing? The short answer is: it depends who you ask.

Joking aside, while ESG and impact investing are materially different, there are probably as many definitions of socially responsible investing fund providers use which obviously confuse investors. So let’s try to see the wood from the trees.

ESG investing

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ESG investing is the integration of ESG criteria into the investment process, primarily focusing on companies’ behaviours rather than their products and services. However, there are two different types of stakeholders using this data leading to two different implementations. 

The first are traditional fund managers who have adopted ESG factors into their financial analysis to evaluate risks and opportunities. Indeed, academic studies all agree on the fact that companies with positive ESG ratings have a lower cost of capital and most studies showed that these companies tend to outperform their peers. 

Following a number of high profile scandals such as Volkswagen, BP and Enron, it is rare for fund managers not to take ESG factors into account as part of their decision making process. 

The second group are fund managers who incorporate ESG screens to design specific strategies that might exclude a particular factor like human rights abuses. These type of strategies are called negatively screened strategies and are often tailored to client specific values. Other ‘best in class’ strategies have been developed, particularly over the last few years by passive fund management groups, and these invest in the best ESG-rated companies across all sectors.

In a recent article, fund manager Terry Smith criticised some of these ESG-screened passive funds for their exposure to tobacco and fossil fuels. 

However, these strategies have not been designed for that purpose. ESG investing should only be seen as the first step towards a more sustainable world. Investors who really want to make a positive difference should look towards impact investing.

Impact investing

This type of investing aims to solve social and environmental challenges by selecting companies which primarily through their products and services create a net positive impact. This approach focuses on finding solutions for unmet needs and increasingly uses the roadmap published by the United Nations for identifying the most pressing issues to be tackled. 

This roadmap comprises of 17 sustainable development goals (SDGs) which are a call for action agreed by 193 countries to end poverty, protect the climate or promote quality education by 2030.

This should not be confused with philanthropy. This approach is very much aimed at maximising both impact and financial returns. Indeed, impact investing is driven by the recognition that finding companies addressing the unmet needs in society represents a structural, secular growth opportunity that can bring wider benefits. 

To avoid risks of green washing, the industry is focusing on the net impact a business is having, not only through its products services but also its operations, often embedding some ESG analysis to their process. The industry is committed to report on that impact achieved not only through case studies but through the use of key performance indicators for the overall portfolio.