Investing can range from fully finance focused to fully impact focused with a load of options in between. Many people think that there is a trade-off between doing good and making a financial return – that to make money, you must forget about your values and morals. In reality, there are many sustainable options where you can invest in a way that makes returns and creates positive social or environmental impact.
What is traditional investing?
The purpose of traditional investing is to maximize your financial return by taking only as much risk as you feel comfortable. There are no limitations related to sustainability. You look at how much risk you are taking and the expected future return in exchange. This method is how investors and companies made most financial decisions until recently. Still, today some investors and companies think in these terms when making an investment decision. Take big oil & gas companies, for example; most of them do not care deeply about the environmental impact of their investment decisions as they continue the exploration & production of fossil fuels. Despite the scientifically proven adverse effects on the climate, they continue these business practices to drive their profits.
What is philanthropic investing?
On the other end of the scale are charity and philanthropy. Let’s say you already have a rainy-day fund and are on track with your savings for your life goals, such as buying an apartment or going on a big trip, but you also want to do good with your money. The obvious solution is to donate to a charity to support a cause you care deeply about. In this case, your primary objective is to make a positive impact without the expectation of financial returns. However, it is important to highlight that you are not preserving your money with charitable donations and philanthropy, and you can’t use them to save for your life goals.
What is sustainable investing?
Sustainable investing is an investment philosophy that considers environmental, social and governance criteria. To put it simply, sustainable investing is everything else which is between traditional investing and charity. Sustainable investing is also often referred to as responsible, ethical, or moral investing. There are three distinct subsets of sustainable investing strategies.
What is socially responsible investing?
Socially responsible investing (SRI) avoids harmful investments that do not align with your values. Which means excluding certain companies from your investment portfolio. As a result, SRI is also often referred to as negative screening. For example, you can avoid investing in fossil fuel companies if you want to fight climate change. Alternatively, you can take a stance against gun violence by not investing in gun manufacturers. If you choose this investment philosophy, it guarantees that you are not investing in something that doesn’t align with your values.
However, this does not mean that you are promoting the most impactful industries or selecting the best companies in a particular sector. However, it is still a better investment strategy from a sustainability perspective. You can mitigate the environmental, social, or governance risk in your portfolio by avoiding controversial investments. If you want to follow this investment philosophy, you should run a negative screening check on your portfolio to see if your investments align with your values. Various organizations promote this practice, such as the leading shareholder advocacy non-profit in the US, As You Sow. Their tool is called Fossil Free Funds. It allows you to check the environmental impact of your investments in your 401(k), retirement plan, or general investment portfolio.
Investors who solely apply the SRI strategy are often criticized for only using it as a risk management strategy by minimizing their portfolios’ negative impact instead of maximizing the positive impact.
What is ESG investing?
ESG (Environmental, Social, Governance) investing is a framework that assesses the financial risk posed to a company by Environmental, Social, or Governmental factors. It’s a strategy that promotes investing in companies that perform well in any or all of three categories: environmental, social, and governance.
For example, it could mean the harm they do or don’t pose to the environment with their practices, how they treat their workers and the communities, and their regard for gender equality among their employees. ESG assessments look at a company’s current practices and provide a score for E, S, and G. The companies are rated according to many factors and receive a final ESG score based on their performance across all three categories. This measurement does not capture the real-term impact of the company’s operation – that would be impact investing. You can read more about the complexities and shortfalls of ESG in our articles Where Next for ESG? and ESG In The News Again – What is it This Time?
ESG investing has three different investment approaches:
- Positive screening (or often referred to as best-in-class screening): applying positive screening means that you are selecting best-in-class companies in a specific sector and avoiding companies below a set ESG threshold (below a specific ESG score). Using this strategy could mean that you are not avoiding an entire sector but are only investing in the best companies in there. Investors using positive screening are often criticized that they do not maximize positive impact this way and only use the strategy as risk management to mitigate the downside. Still, this strategy is considered successful, especially if you combine both the negative (SRI) and positive screens for your investments, which gives you something closer to an ESG integration strategy.
- Active ownership: The active ownership strategy means investing in companies with harmful practices to influence them by voting in their board meetings to change their strategy. You could achieve this by investing in funds whose managers are known to vote in line with your values. However, you need to be careful following this strategy as some investment managers don’t walk the talk. Some asset managers are re-branding their traditional investment funds as ESG funds but are not voting in line with these values. If you want to pursue this strategy successfully, you need to check the investment funds and investment managers and need to follow up with the managers if you feel that your values are not represented in boardrooms.
- ESG integration: ESG integration integrates ESG factors into traditional investment processes to improve long-term portfolio risk/return. When done right, ESG integration is the next evolutionary step in sustainable investing from socially responsible investing. It also avoids the sectors where your values are not aligned while also allowing you to invest in the best scoring companies from an ESG perspective. While there is no perfect framework for ESG integration, efforts are being made by the CFA Institute and the Principles for Responsible Investment (PRI) to create “a best practice report” for equity and fixed income investments.
What is impact investing?
According to the Global Impact Investing Network’s official definition, “impact investments are investments made to generate positive, measurable social and environmental impact alongside a financial return.” Impact investing is always very specific, targeting a selected issue resulting in a thematic investment strategy. These issues often align with the United Nations Sustainable Development Goals or SDGs – such as gender equality, climate action, no poverty, or reduced inequalities. There are 17 goals in total, and multiple investment managers chose this framework to showcase their impact investing strategy. There are two very distinct strategies of impact investing which is differentiated by their financial return potential: thematic impact investing and impact first investing.
- Impact Investing – Thematic impact investing. If you want to pursue an impact investment strategy where, besides the targeted environmental and social impact, you like to outperform the market and aim for high financial returns, you are following thematic impact investing. There are specialized active fund managers who pursue this strategy and regularly monitor their portfolio companies to ensure impact is generated along with their expectations. Targeted themes include, amongst many others, healthcare, climate change and microfinance.
- Impact Investing – Impact first investing. If you, besides the targeted environmental and social impact, are potentially willing to sacrifice some (but not all) of the financial returns and earn a below-market rate with your investments, you are pursuing the impact first investing strategy. The goal here is to preserve your money with some financial return while aiming for a high impact. It is important your goal is not to lose your money with your investments. If you are losing your money, then it is the same category as philanthropy or a charitable donation, and you are no longer investing sustainably. Impact first investing can be powerful, and strategies include investing in social enterprises. There are not many investment vehicles on the market doing impact first investing, and they are currently primarily available for professional investors. Impact investing is the most effective sustainable investing strategy.
The first step in deciding which strategy to adopt for your investments is understand what they each do and don’t mean. There are many options to do well for your money and do good for the planet. Which approach will you choose?
Footnote 1: Content is for informational and educational purposes only. Any views, strategies or products discussed may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. The information contained herein should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund or ETF before investing.