ESG Investing vs. Impact Investing: What is the Difference?
Learn more about how your investments can drive positive social and environmental change.
By Asiyah Choudry
October 28, 2021
As global awareness of climate issues increases, financial products are increasingly being looked upon as drivers of social change. As a result, sustainable investment strategies like ESG investing and impact investing have grown in prominence over the past decade, incentivizing businesses to be more socially and environmentally conscious. According to a 2019 report from Morgan Stanley, 95% of millennials are interested in sustainable investing. But for the average investor looking to make their portfolio more sustainable, it may not be immediately clear how ESG investing and impact investing differ.
Both impact investing and ESG investing have their advantages and disadvantages. You may find that you prefer one over the other depending on your goals. Let’s examine the differences between the two approaches.
What is ESG investing?
ESG investing is an investment strategy that evaluates companies based on environmental, social, and governance risk factors alongside traditional financial metrics. According to Morningstar, in 2020, investors funneled a record-breaking $51.1 billion into ESG funds, while the number of ESG funds available to US investors increased by 30%. Thus, it is evident that ESG funds are rapidly growing in popularity — but how are stocks and bonds screened for inclusion?
Some examples of the factors used to evaluate an investment for inclusion in an ESG fund include:
- Environmental factors such as carbon emissions, pollution, or climate change policies
- Social factors such as human rights, workplace policies, or employee compensation
- Governance factors such as financial transparency, executive compensation, or the board of directors
If a firm has a low ESG risk profile, this may be indicative of future success. But if a firm has a high ESG risk profile, this suggests that poor environmental, social, or governance performance may negatively affect performance in the long run.
However, there is still ambiguity associated with ESG ratings. No standard method for applying ESG criteria exists in the US. As a result, rating companies may arrive at different conclusions regarding the ESG risk profile of an organization. For example, Sustainalytics gave Amazon a high ESG risk rating, whereas Refinitiv rates Amazon above average on ESG performance.
It is also important to note that ESG is not synonymous with climate-friendly. ESG funds may include stakes in oil and gas companies. For example, the SDPR S&P 500 ESG ETF, which includes “sustainable” firms from the S&P 500, has holdings in Chevron and Exxon — two of the largest oil producers in the US. While there is currently limited oversight of ESG in the US, this is expected to change soon.
In response to growing investor demand for ESG, the Securities and Exchange Commission (SEC) indicated that they are considering regulating ESG funds and climate risk disclosure in their Spring 2021 Regulatory Agenda. Earlier this year, the SEC launched a Climate and ESG Taskforce under the Division of Enforcement to “proactively identify ESG-related misconduct,” including misrepresentations of climate risks. While the SEC has yet to develop any new regulations, it seems like increased oversight of ESG is on the horizon.
In the meantime, make sure you thoroughly investigate the holdings of your ESG funds to make sure there isn’t any greenwashing!
What is impact investing?
Impact investing seeks to create a positive social or environmental impact, in addition to a financial return. rom 2019 to 2020, the impact investment market grew from $505 billion to $636 billion. That popularity sparked the emergence of crowdfunding platforms like Raise Green, which has made impact investing more accessible to the average investor.
A distinguishing characteristic of impact investing is the broad range of investor return expectations. The foundation of impact investments is the creation of a positive impact, sometimes at the expense of profit. According to the Global Impact Investment Network (GIIN), roughly 33% of investors target returns below the market rate.
Impact investment currently faces many of the same challenges as ESG investing. These include the definition and measurement of the word “impact,” over which there is currently no regulatory oversight in the US. As the market grows, there will be an increased need to standardize this definition to avoid impact washing.
To provide investors with clarity, the GIIN has identified four core characteristics of impact investing:
- Intentionality: Impact investors aim to solve complex problems to create positive environmental or social outcomes.
- Evidence-based decision-making: To effectively create environmental or social benefits, investments need to be rooted in an evidence-based need. High-quality data is also an essential part of evaluating the performance of an investment against its targeted impact.
- Managing performance of investment: Impact investments are oriented around the intention to create a positive impact. Therefore effective management is needed to move towards impact creation. This entails risk disclosure and measuring and reporting impacts.
- Advancement of the impact investment industry: This includes sharing lessons learned, using industry-standard language and conventions, and retroactively evaluating impact management practices.
How do ESG and impact investments perform?
The majority of investors care about their bottom line first. A study conducted by the University of California found that the median internal rate of return for impact funds is 6.4% — only slightly lower than traditional funds, which have a median internal rate of return of 7.4%.
Similarly, an examination of 1,000 studies of ESG and financial performance found an overall positive relationship that became more pronounced over time. There is also some evidence to suggest that low-risk ESG funds are more resilient in periods of uncertainty. For example, in the first year of the pandemic, ESG funds outperformed the S&P 500.
Align your investments with your values
ESG is a starting place for developing a better understanding of an organization’s environmental, social, and governance practices. Impact investing allows you to create measurable positive, social or environmental change. Since both lack stringent oversight, it is important to do your due diligence to ensure that any investment you look at isn’t greenwashing or impact washing.
GreenPortfolio makes the process easier for those looking to take climate action with their finances. Take a look at our list of climate-friendly mutual funds, ETFs, and bond funds to get started today.
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