SRI vs. ESG vs. Impact Investing: What's the Difference?
How do values-based investors decide among SRI, ESG and impact investments? We look at what sets each strategy apart.
2021 has been a year marked by uncertainty, but also by conviction – and as a result, many investors are looking to align their portfolios with their principles.
Values-based investing is not an overnight sensation. According to US SIF: The Forum for Sustainable and Responsible Investment, socially responsible investing (SRI); environment, social and corporate governance (ESG) investing and impact investing assets grew from $3 trillion in 2010 to $12 trillion in 2018 to $17.1 trillion by the start of 2020.
The trend shows no signs of subsiding anytime soon. Financial industry research further indicates that 85% of the general population and 95% of the millennial population are interested in sustainable investing.
There is a wide variety of values-based investing approaches and strategies. But deciding how to incorporate them into a portfolio depends on a number of individual factors.
SRI, ESG and Impact Investing: What's the Difference?
When it comes to choosing values-based investments, investors and their advisors need to understand the differences among SRI, ESG and impact investing:
- Socially responsible investing (SRI) entails screening investments to exclude businesses that conflict with the investor's values. SRI dates back to John Wesley, the founder of the Methodist movement, who urged his followers to avoid investing in "sin stocks" that generated profits through alcohol, tobacco, weapons or gambling. Common SRI exclusions in modern times include fossil fuel producers and firearms manufacturers. SRI is the simplest (and often the least expensive) values-based investing approach.
- Environmental, social and corporate governance (ESG) investing focuses on companies making an active effort to either limit their negative societal impact or deliver benefits to society (or both). The Sustainability Accounting Standards Board (SASB) aims to standardize the ways companies report on ESG criteria to better inform investors, including determining which ESG issues companies should prioritize based on sector and industry. An example of an ESG investment might be buying stock in a technology company that converts one of its data centers to use renewable energy, resulting in cost benefits as well as a positive effect on the environment.
- Impact investing is characterized by a direct connection between values-based priorities and the use of investors' capital. These funds not only report on financial performance, but they also try to generate and quantify a positive societal impact — for instance, number of schools built, measures of economic activity in a low-income community, or reduction of carbon footprint by X units. Impact investors are often able to deploy funds in service of causes that are not directly addressed by the public financial markets, such as community development and poverty alleviation. These funds also tend to have more influence on the execution and management of portfolio companies than do other investment vehicles.
It's important to note that impact investing refers to private funds, while SRI and ESG investing involve publicly traded assets. For investors who seek transparency about the specific ways their capital is being applied to a particular cause, impact investing might be a more attractive vehicle than ESG or SRI. Determining the direct impact of money invested in a broadly diversified mutual fund can be challenging.
Additionally, public companies still have the ultimate mandate of generating shareholder value through stock price appreciation, which may conflict with values-based priorities.
That said, due to their private nature, impact investing vehicles tend to be less easily accessible than publicly traded options.
One Size Doesn't Fit All
For investors looking to explore values-based investing, the first question to ask is "Which values do you want to prioritize and reflect in your portfolio?" Is the investor more concerned with a company's environmental footprint, or their social footprint?
Values are deeply personal, and there are a number of ways to approach values-based investing. Fortunately, the variety of vehicles and strategies available means that investors and advisors can customize a portfolio to suit their individual priorities and goals – while also taking into consideration factors like volatility, liquidity and income requirements.
Investors who are new to values-based investing may also want to take a gradual approach to adjusting their portfolios. A good place to start is by making values-based changes to equity allocations, and then reflecting after a year or two: Are the returns in line with your expectations? Is aligning your investments with these values still a priority?
Values-based investing can be defined in different ways depending on whom you ask. But understanding the fundamental distinctions between SRI, ESG and impact investing can help investors and their advisors construct a portfolio that reflects their specific goals and beliefs.