Demystifying ethical investing (ESG vs. SRI vs. Impact Investing)

The short version

• Ethical investing is not a new subset of investing, but it’s more available to the average retail investor than it ever has been.
• ESG investing grades companies based on their environmental, social, and governance practices
• SRI excludes companies that don’t comply with an individual’s ethical or religious convictions – and is highly personal.
• Impact investing focuses on companies that directly do social good – with the hopes of high returns

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Origins of ethical investing

The practice of ethical investing dates as early as the beginning of the 1900s when the Methodist Church of North America decided to change their views of the stock market (up until that point they considered it gambling) and use it to grow their wealth.

But the Church had strict rules about which companies they would invest in, banning companies that supported, produced, or benefited from alcohol or gambling. The Quakers adopted this unique portfolio and added weapons manufacturing to the list.

The first ethical investing fund was launched in the US in 1971. The Pax Fund was a direct response to the Vietnam War and excluded companies that profited from what they deemed a morally questionable insurrection. Companies like Dow and Monsanto, manufacturers of Agent Orange, a defoliant sprayed on Vietnamese jungles that caused congenital disabilities, were excluded from the fund.

Over the last century, ethical investing had mostly been reserved for religious or cultural groups with enough capital to warrant managing their own fund. Still, the rise of retail investing in the past 20 years now means that anyone can access ethical investing portfolios.

During that time, ethical investing as a category of investing has become more specialized. Today, you can choose from different funds that adhere to Environmental, Social and Governance ESG, Socially Responsible Investing, or impact investing criteria.

It all depends on what type of impact you want your money to make.

Comparing ethical investing strategies: ESG vs. SRI vs. impact investing

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Socially responsible investing (SRI)

Socially responsible investing is the most traditional type of values-based investing and is what the Methodist Church engaged in all of those years ago. SRI looks to avoid companies that don’t comply with the investor’s moral, ethical, and religious convictions. An example of SRI is an investor who is against consuming meat, refusing to invest in Cargill, a multinational livestock company.

The result of SRI is that you put social consciousness above returns, so you might not earn as much from your SRI portfolio as a non-SRI portfolio. But for most investors who make that choice, ethics are more important than returns.

You have several options if you want to change your investment strategy to SRI. First, you can choose to invest in an SRI fund. An SRI fund is the most straightforward method, but has the downside of not enabling you to choose based on your unique convictions. Instead, you’ll have to invest in companies that a third-party fund manager has deemed SRI appropriate.

One example of this fund is the 1919 Socially Responsible Balanced Fund (SSIAX). This fund is one of the oldest SRI funds, established in 1992. It has $700 million in assets under management and comprises 30% low-risk investment grade bonds and 70% stocks that conduct business in a “socially responsible manner.”

Another option is to use a robo-advisor. Some robo-advisors, like Betterment, offer SRI portfolios for users who want everything about their investments to be socially conscious.

Finally, suppose you’d prefer to build a portfolio yourself that is 100% compliant with your convictions, you can use an SRI screener like this one offered by Fidelity, which lets you screen both ETFs and individual stocks to see how socially responsible they are.

Find the best Robo Advisor for you>> Leading robo advisors for socially responsible investing

Environmental, social and governance (ESG) investing

ESG investing stands for environmental, social, and governance and represents a group of criteria through which companies should be screened in order to qualify. It was first popularized in 2005. The idea behind ESG investing is that financial managers and investors should look beyond pure profitability and consider factors in the environmental, social, and governance space when deciding whether or not to invest in a company. Some focus areas of ESG criteria include:

Environmental

• Greenhouse gas emissions
• Water use, waste and pollution
• Land use

Social

• Workforce diversity
• Safety management
• Engagement with local communities

Governance

• Board composition
• Code and values
• Political contributions
• Whistleblower protocols

ESG is different from SRI investing. ESG doesn’t necessarily exclude companies that are associated with adverse outcomes, but it ranks them poorly based on those outcomes. S&P Global uses the above mentioned factors to conduct its ESG Evaluations and grade companies. ESG has grown substantially. In 2018, the level of ESG investments was at $31 trillion, a 34% increase over 2016 numbers.

An example of ESG funds includes the Vanguard FTSE Social Index Fund (VFTAX, which tracks the FTSE4Good US Index.

• This index excludes companies that deal in “vice” products like adult entertainment, alcohol, gambling, and tobacco.
• It also excludes non-renewable energy companies dealing in nuclear power, oil and gas, and weapons manufacturers.
• Finally, it excludes companies with controversial conduct and diversity practices.

So what does the Vanguard FTSE Social Index Fund include? You’ll find companies like:

• Apple Inc
• Microsoft Corp
• Amazon.com Inc
• Alphabet Inc Class A (Google’s parent company)

While some of these companies may not fit everybody‘s idea of guilt-free investing, they do adhere to the criteria while balancing out returns.

More: How to know if a company or fund is really ESG

Impact investing

ESG investing is a criterion to evaluate investments. SRI lets you invest according to your convictions. These investment styles aim to exclude companies that don’t measure up. Impact investing, on the other hand, seeks to include companies whose explicit mandate is to have a positive impact on society.

This type of investing has risen in popularity over the past decade, but there is still some risk to choosing this investment strategy. Impact investors usually choose companies that follow market trends and might be newer and less established — like solar panel companies or electric car start-ups. This choice could lead to higher than average market returns, or it could lead to significant losses.

To get into impact investing, you’ll need to put your research hat on. Unlike SRI and ESG, there aren’t any widely available funds in this space. Instead, you’ll need to seek out opportunities to invest in and support those companies directly.

Here are some popular ways to start impact investing:

• Buying stocks of a company that is looking to make a significant and positive impact on the world (like an electric car company or a solar company)
• Offering small loans directly to small businesses that propose to make a significant impact in their local community
• Setting up private funding to finance resources in low-income communities, like affordable housing collectives or healthy food retailers

Remember that impact investing is about investing. It’s not a charity, so you should always expect to receive a good return.

More: What is Impact Investing?

How to decide between ESG, SRI, and Impact Investing

There is quite a bit of overlap between ESG, SRI, and impact investing, so let’s go over the definitions again:

• SRI: Eliminates companies that don’t comply with the investor’s ethical or religious convictions
• ESG: Evaluates companies based on more than just their financial return, prioritizes those who also do good
• Impact investing: Seeks out companies that make a significant positive social or environmental impact

Which strategy you choose depends on what you want to achieve with your dollars. For example, if you want to invest normally, but you’d prefer to focus on companies that do good in addition to earning a good return, ESG is right for you.

If the most critical aspect of your investment portfolio is to avoid or exclude companies that don’t suit your moral convictions, SRI is right for you.

Finally, if you want to have your dollars make the largest possible positive impact on society, impact investing is for you.

More: What is faith-based investing

What type of ethical investing is right for you?

ESG, SRI, and impact investing are not new terms. Years of data have revealed that ESG and SRI portfolios can perform as well as non-ESG or SRI portfolios.

So if you want to earn a return on your money without investing in companies that are bad for society or the environment, in our opinion going the ESG or SRI route is a good option.

Impact investing is a little riskier and requires more time and research. But if you want your money to make a big impact, investing a portion of your portfolio into impact investing could generate excellent returns.

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