How Do ESG, SRI, and Impact Funds Differ?

A growing number of investors are demanding investment choices from their advisors that do more than provide them with a rate of return.

Younger investors, in particular, are seeking out options that will not only help their assets to grow but also benefit society at large in some respect. This is referred to as responsible investing.

A 2021 survey of investors by financial services organization TIAA revealed that 53% of those polled own some form of socially responsible investment (SRI).

Furthermore, investors polled strongly believed that financial advisors should be knowledgeable about SRIs. Of the total group, 79% stated that they would be more loyal to a financial advisor who helped them make positive impact investments.

There are several categories of investments that do this, including SRIs, environmental, social, and governance (ESG) options, and impact funds. Advisors and investors need to be able to recognize their differences to invest funds appropriately.

Similarities and Differences Between Responsible Investments

The broad category of investments that provide more than a rate of return can be classified according to the emphasis that is placed upon the investment’s financial performance.

Range of Socially Responsible Opportunities

Patrick Drum, a portfolio manager at Saturna Capital, led an effort by his firm to help advisors understand these investments. He created a spectrum of socially dimensioned investments called the Sustainability Smile.

On one end of the spectrum are purely traditional investments that are purchased solely for their profit potential, regardless of a lack of social impact.

Integrated Investing

The next category is integrated investing, which takes ESG impact into account but still makes a point of generating investment returns.

“ESG is about financial performance but takes into consideration a broader set of due diligence questions on how environmental, social and governance facts drive or inhibit performance,” Drum told ThinkAdvisor in an interview.

ESG is a focus, but the ultimate goal is to produce optimal results with the invested money.

Ethical Investing

The next step along the spectrum and away from a pure profit motive is labeled as ethical/advocacy investing. This approach attempts to balance profit with the investor’s beliefs by excluding certain segments such as sin stocks (e.g., companies involved with alcohol, tobacco, or firearms).

In the Saturna Capital white paper, Drum gave an example of this type of investment, citing a movement called the Carbon Divestment Campaign. It challenges and encourages companies that deal in carbon, such as oil companies, to move further into the realm of renewable energy.

The return on capital still matters here, but Drum says there is a “level of ‘return forgiveness’” present as well.

Impact Investing

Drum labels the next option as thematic/impact investing, where financial performance is secondary to the investment’s social theme or impact.

The main objective is for companies to accomplish social goals. The investor may still seek to generate an investment return, but this is unconditionally subordinate to the social aspect of the investment.

Philanthropic Investing

The final category of investment is purely philanthropic, where no thought is given to the rate of return that is earned, if any.

Government Involvement

In late October 2020, the U.S. Department of Labor released a regulation intended to limit or eliminate SRI in retirement plans. While the rule was revised to remove explicit references to ESG factors, it mandated that fiduciaries of retirement plans must choose investment strategies based entirely on how those strategies affect financial performance.

In October 2021, a new proposal was made to help retirement plan fiduciaries safeguard workers’ savings by allowing fiduciaries to consider climate change and other ESG factors when they make investment decisions.

The Bottom Line

In 2021, the CFA Institute surveyed more than 700 financial advisors and research analysts about ESG integration. The survey revealed that about a third of respondents believed that ESG integration should always occur. About 48% believed that ESG integration should only occur if an advisor finds it financially relevant to making a particular investment.

While 80% of respondents believed there should no market regulation or government mandates concerning ESG integration, 62% believed there should be a “globally consistent product disclosure standard” to prevent greenwashing. Greenwashing occurs when a company claims falsely that its products are environmentally sound.

Since 2016, Morningstar Inc. has assigned to investments a globe rating that measures social impact. Advisors and investors who are interested in socially impactful investing can use this rating to help determine whether a given investment choice satisfies their social criteria.