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Defining the Industry: SRI, ESG, and Impact Investing

Though nonfinancial considerations have moved more to the forefront of investing in recent years, the terms used to describe this transition can be a source of confusion, from SRI vs. ESG to how impact investing fits into the equation. As investors navigate the wide spectrum of choices now available from asset managers, pinning down the meanings of the various labels and acronyms in use can help clarify goals and strategies, ultimately helping to solidify the industry’s identity.

SRI

“Socially responsible investing,” or SRI, emerged in the late 1960s, arising at the tail end of the US civil rights era, alongside growing opposition to apartheid in South Africa, and against the backdrop of the Vietnam War.

This early brand of sustainable investing surfaced in response to rising demand for investment funds that avoided areas certain groups deemed unethical. For example, universities, nonprofit organizations, and religious institutions increasingly stipulated that their portfolios exclude or withdraw investment in the likes of tobacco or weapons manufacturers, as well those with significant business interests in South Africa.

Today, along with stocks in industries such as defense, tobacco, and alcoholic beverages, SRI funds often also exclude investment in oil producers on environmental grounds. While some investors have been willing to accept the greater risk of below-market returns that can come with divestment, more recent debates around environmental risk factors have many calling for institutional investors to pull out of fossil fuels to protect portfolios. SRI funds may also overweight sectors such as technology, financials, or healthcare, where their ethical restrictions do not apply.

ESG

From the negative screening of socially responsible investing came a movement toward strategies that consider how different sustainability factors may positively impact both the world and the bottom line.

The term “ESG” was coined in 2005 with the publication of the study “Who Cares Wins.” According to index provider MSCI, the definition of ESG investing is “the consideration of environmental, social, and governance [or ESG] factors alongside financial factors in the investment decision-making process.” An investment manager claiming to be operating an ESG strategy should therefore be expected to actively consider all four of these elements.

But there’s an important caveat: while a fund manager may state that a given strategy accounts for ESG-related risks, this doesn’t necessarily mean that the fund is precluded from investing in areas that traditional socially responsible investors might view as unethical. This is due in part to the variability in different third parties’ ESG rating systems. For example, the Wall Street Journal notes that an electric car manufacturer and an oil company can come out at the top or bottom of ESG rankings depending on the details of the rubric used. In contrast, a manager following a typical SRI mandate that excludes all fossil fuels stocks on ethical grounds would never consider an investment in an oil company, while it may see an electric car manufacturer as a natural fit.

ESG analysis is also commonly used in association with shareholder engagement, according to the Principles for Responsible Investment. Through dialogue and resolutions put forward for voting at annual meetings, shareholders have held companies accountable on a range of ESG-related issues, from asking fossil fuel companies for better climate change reporting to requesting that corporate boards detail their efforts to improve diversity.

Impact Investing

More easily grasped than acronyms like SRI or ESG, the newer term “impact investing” has become something of an industry catchall. However, it has its own definition with unique points of emphasis. According to the Global Impact Investing Network (GIIN), “impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” In other words, what sets impact investing strategies apart from those described above is that they unambiguously target tangible beneficial outcomes. As with ESG, impact investing seeks to achieve impact with the dual objective of earning competitive returns for investors.

Impact investing casts a wide geographical net and spans a variety of asset types, including bonds as well as public and private equity. It also incorporates investments in a variety of sectors, from renewable energy and microfinance to more traditional areas such as housing, healthcare, and education. While the GIIN highlights the wide range of return profiles and asset types on offer in the impact investing segment, it also emphasizes the importance of being able to objectively measure social and environmental impacts. Impact measurement is an often-discussed challenge, but one on which the majority of respondents to the GIIN’s 2018 annual survey said they had seen “significant progress.”

Ultimately, clarifying SRI vs. ESG vs. impact investing is only to tackle the most commonly circulated (and interchanged) terms. As the US Forum for Sustainable and Responsible Investment notes, a number of other labels have entered the conversation to describe a set of related investment strategies, from green investing and community investing to values-based investing and mission-related investing. This diverse assortment of terms reflects the variety of motivations that draw investors toward a focus on responsibility and sustainability. While settling on one name to cover them all might be convenient, defining each on its own can help investors choose the specific strategy that best suits their needs.

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