Ethical Investing Guide: Everything you need to know about ESG and SRI

When investing ethically, there are a lot of different approaches you can take, but what’s the difference and what do they all mean? Find out in this guide to ESG, SRI and Impact Investing.
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In the last decade or so, the world has become far more active when it comes to environmental and social issues. And this activism has spread into investing, with people wanting to use their money and their investments to make a positive difference in the world. This type of investing has been growing rapidly across Europe, increasing by 2052% from 2005 to 2015.[1] But it’s not just Europe either, across the pond in the US, sustainable investing accounts for $1 out of every $4 that’s professionally managed.[2]

 

Defining what ‘ethical investing’ is
The figures may show that ethical investing is on the rise, but what exactly is it? This is an issue that arises constantly as the term ‘ethical’ means different things to different people. But, the one thing that’s agreed on is that ethical investing is a strategy you take when you want your money to be used in a way that aligns with your values – whether that’s social, moral or even religious.

But why does this matter? There are a number of ethical issues related to investing in stocks, from profiting off debt to being invested in activities like weapons manufacturing or oil production. If you’re purely investing to make a profit, then this may not concern you, however a growing number of investors are looking to use the power of investing to improve environmental or social causes. We’ll go into this in more detail in a bit.

 

Why do people invest ethically?
Ethical investing is believed to be started by religious groups who wanted to restrict what their members spent their time or money on. This practice still continues today and is seen prevalently within Islamic banking and investments, which actively exclude investments in alcohol, gambling, and pork among other things. This method of ethical investment works on an exclusion basis, refusing to invest money in companies who go against religious practices or ethical values.

But you don’t need to be religious to adopt ethical investing. The essence of this strategy is that you invest in a way that aligns with your moral values, you could choose to invest in line with what you believe is right. For example, if you are a vegan you may wish to avoid investing in companies who exploit animals, doing this would be an ethical investment – similarly, if you’re a climate activist then avoiding companies where their activities damage the environment is another form of ethical investments.

Until quite recently, this form of ethical investing – known as exclusion as you’re actively avoiding certain industries and companies – had to be done manually, involving a lot of research, and requiring you to deliver your own ethical approach. However, with this increase in people wishing to invest both ethically and socially responsibly some providers started to make ethical investments a priority. This then saw the increase in available ethical funds (which are like a collection of ethical investments) allowing for a wide range of different ethical investments to be purchased quickly and easily.

 

What is ESG investing?
ESG stands for environmental, social, and governance. What this means is that these are the three criteria that need to be considered for any investments to be included in an ESG managed plan. Essentially, ESG provides a framework of standards that allow investors to screen their investments during their research and evaluation process.

To break ESG down further, we need to look at each aspect to provide the bigger picture:

  • Environmental considers the carbon footprint of the company and what it is doing to help fight against climate change
  • Social looks at how relationships are managed by the company, including their treatment of staff, customers, suppliers, and what it is doing to help improve the communities where the business operates
  • Governance considers the company’s leadership, financial audits, executive pay, shareholder rights, and the company’s internal controls.

Each of these areas is examined by a third-party provider, who will provide each company with a report and a rating. As these reports are done by several independent providers, there are different ratings provided, which we’ll go into later in this guide.

It’s important to note that ESG is not a different type of investment, or even a strategy of investing, it is simply a measurement to gauge how ‘ethical’ a particular investment choice may be.

 

How do ESG criteria work?
In a nutshell, a company is assessed based on what they are doing environmentally, socially and through governance. Each of these core principles covers a wider range of issues, such as how much energy a company uses, how much carbon emissions they produce, if the suppliers they work with hold the same value, how they treat employees and stakeholders, and how accurate and transparent their reporting is.

All of these things are looked at and considered by one (or several) third-party assessors, who each have a different scoring category. For example, Bloomberg ESG Data Service provides a rating out of 100 which is evaluated annually and looks at 120 different indicators. But the MSCI ESG Research on the other hand has a scale that runs from AAA-CCC and looks at 37 key issues that are divided into three pillars and ten themes.[3]

Why does this matter? Just because a company passed ESG criteria from one assessor doesn’t necessarily mean they’ll pass all of them. Similarly, they may pass in one area and fail in another – for example, they’re working hard on their environmental impact, but they aren’t as transparent as they should be with their governance. For this reason, many investors using ESG criteria may have to decide which values they choose to uphold and where they don’t invest.

Most ESG investors want their money to do good, but their main focus is to make a return on their investment. Even with conventional investing, ESG criteria can help to avoid negative purchases in companies facing potential, recent or ongoing controversies, such as workplace discrimination, fraud, or even animal welfare.

 

What is SRI?
Socially Responsible Investing or SRI, can also be referred to as Sustainable, Responsible and Impact Investing, and is an investment practice that uses the ESG criteria as a part of the investing decision when looking at long-term investments that deliver a positive impact. Where with conventional investing, your sole aim is to achieve a profit, with Socially Responsible Investing you aim to find a balance between making a financial gain and delivering social good.

The confusion comes in, as ESG criteria can be very closely linked to many SRI approaches. In general, these scoring platforms are used to get a better understanding of how a company operates.

However, while ESG is used to assess all companies on where they stand, SRI goes further by taking into consideration the nature of the business. This means that they typically invest in companies who actively aim to deliver a positive social impact, either by engaging in social justice or environmental sustainability.

Taking an SRI approach will normally remove entire industries based on being unethical, this could include things like alcohol, gambling, weapons manufacturing, tobacco, and adult entertainment, but can also be pushed further to include other controversial industries such as fast fashion, air travel, or oil production.

Just as there are many different assessment providers of ESG, there are several SRI strategies that can be used, and they are not all the same. Negative screening is the most commonly applied one, following the ‘exclusion’ method touched on at the beginning, but there is also the option to deliver positive screening, which looks at companies that you approve of and whose work is driving positive change. Combining these two approaches can be a lot of work as it involves regular research, fact checking, and audits, but there are solutions out there that provide actively managed ethical funds allowing you to invest in this way without the added hassle.

Another SRI approach is to use their shareholder status to try and influence the behaviour of a company. See, when you buy a share you may also get voting rights, and the more shares you have the more of a say you’d have. So, if you or a group of like-minded investors have enough invested in a company then you could influence the voting and change the practices of that business for the better.

One common use of SRI is in ‘thematic investments’ – which focus on a specific area and aim to deliver a positive impact with their investments. For instance, an investor may choose a ‘clean energy thematic investment’, which looks to invest only in companies and organisations who are actively working to deliver clean energy or innovations, and improvements to that area. When done in this way, it is often referred to as impact investing.

 

What is impact investing?
Impact investing is a form of Socially Responsible Investing with a specific aim – to use investing to deliver positive social and environmental results. In addition to taking socially responsible considerations into account, the aim of impact investing is to reduce the negative effects of business. For this reason, an impact investor may look at a company’s Corporate Social Responsibility (CSR) policy or the impact they are trying to deliver before investing.

Typically, the goals of impact investing change to follow the current challenges that the world faces. For example, you could engage in impact investing across healthcare, education, affordable housing, sustainable agriculture, renewable energy, microfinance, conservation, and even providing access to basic services in a specific country or area.

While impact investment may focus on a certain goal, it can do this while investing in a wide number of industries and many different investment types, allowing for a diversified plan. It’s important to note that because impact investing as a strategy is designed to deliver a positive social outcome, it may not always aim to produce a positive financial return as well. For example, you could invest in a non-profit organisation looking to expand the availability and affordability of clean energy, which may not deliver any results. Choosing to support this business because of the ethical values behind it, rather than the monetary values it could achieve, could make you an impact investor.

 

What’s the difference between ESG and SRI?
In the description of the two types of investing, you may have noticed that there are some significant differences. But, it’s important to also understand that the two can work very closely together. In fact, many SRI investors will use ESG criteria to help guide their decisions and build portfolios tailored for both long-term financial returns and positive social and environmental impact.

Considering how closely these are linked, it’s no wonder the ESG and SRI are commonly confused. In fact, rather than being different, it could be easier to think of them as two strategies on different sides of the spectrum. The spectrum in this instance is financial impact first, with social outcomes secondary, and social impact first and financial outcome as secondary.

Conventional investing in this situation would be one side of the board, with a focus being primarily to maximise financial return. Its polar opposite then would be philanthropy, with money invested into causes to improve the social or environmental situation with no intention of seeing a financial return.

On this spectrum, ESG criteria typically leans towards looking at the financial implications first, before other issues are addressed, while SRI would aim to balance financial returns with positive impact.

How this works in real life is that an ESG investor may choose to invest in a company where their main practice goes against their ethical values, – for example Shell, who are in the oil industry – but who scores well on ESG criterion for their investment in clean energy and reporting on their carbon footprint among other things. With SRI investing, this entire industry is likely to be avoided, despite any good work and achievements they may produce, as the oil industry directly contributes to climate change.

In the most basic principal, Socially Responsible Investing is driven by ethical values, while Environmental, Social, and Governance looks at a number of factors to better understand a company’s long-term sustainability to achieve higher investment potential. Where SRI will use negative screens to avoid entire industries, ESG rankings are attached to a specific company allowing for a more detailed approach, although this means that a poor ranking wouldn’t necessarily exclude a company.

Essentially, an SRI approach is defined by the investor. It’s their choice what industries they wish to support and how they want their money used, while ESG is a broad set of factors that can help to guide investment selection regardless of whether you’re investing ethically or not – after all, good governance, shareholder rights and transparency are always good traits to look for.

 

Does ethical investing offer less returns than conventional investing?
Very few people are looking to invest without the prospect of making a profit, and for a long time there was an assumption that ethical investing reduced your chances of making a return. Perhaps unsurprising, considering that many chose to exclude large industries and several big companies. But the truth is, ethical investing can perform as well, and in some cases better, than conventional investing.

However, for nearly 20 years it has been proven that there was no evidence of a statistically significant difference in return between ethical and conventional investments. This followed a study in the year 2000s, looking at the difference in returns between ethical and standard investments across the UK, US and Germany between 1990-2001.[4]

And that wasn’t just a one off either. If we’re looking at the performance of the FTSE All Share, which lists over 600 UK companies, and the FTSE4Good which focuses on companies looking to make a positive impact on the world, then between September 2013 and 2018 ethical outperformed standard by 0.7%. In that five-year time period, the FTSE All Share returned 43.3% compared to the FTSE4Good showing a return of 44.1%. [5] What that means is that during this time period, if you’d invested £5,000 in funds that tracked both indices, then you may have had £35 more profit in your ethical investments – but, you would have also been investing in line with your values.

 

Balancing risk with ethics
Just because an investment is ethical doesn’t mean it isn’t risky. In fact, if your approach to ethical investing is to not profit off debt then it may rule out lower-risk investments like bonds, which could increase your exposure to market movements.

However, there are plenty of ways that you can work to mitigate the risk of your investments. For example, you can spread your money across a large number of regions, many different companies, and maybe even look to help support several causes so that your performance doesn’t rely on a handful of similar investments.

Luckily, as ethical investing has risen in popularly, so too have ethical investments, bonds and even entire industries – like green energy. The first ‘green bond’ was released in 2007 by the European Investment Bank, designed to fund renewable energy and energy efficiency projects, and in 2018 the Seychelles launched the world’s first sovereign blue bond, to support sustainable marine and fisheries projects.[6]

What this means is that there are no shortage of options when it comes to ethical investing, allowing you to spread your money and risk in a way that best suits your needs.

 

Things to watch for with ethical investing
While ethical investing has many benefits, there are also a few things that you may want to watch out for. For example, due to the additional checks and research required, the investment charges can be more expensive. This is something to consider as higher fees can eat into your returns, so it may be worth asking yourself if you’re happy to pay a little bit more to invest in line with your values.

Not all ethical investing options are the same either, and the charges from one provider may be greater than that of another. It could be a good idea to shop around and find a provider who offers competitive costs and charges.

Additionally, you may wish to consider how that provider is managing your ethical investments. While passive ethical investments can be considerable cheaper, they don’t tend to apply both positive and negative screening processes to ensure that your ethical investments stay ethical. If the provider delivers active ethical investments on the other hand, they would typically run regular checks to ensure the funds they are invested in, and the companies within those funds, are maintaining a high standard. As this is a more manual process and can take a considerable amount of time, some providers may charge more money for this service than passive ethical or even conventional investing strategies.

It’s also worth noting that if you’re using funds, or a managed investment service, then you may have to make compromises. This is because these services are used by a large number of people, all of whom have slightly different values, so the investments tend to encapsulate the ones that the most people care about, but obviously would struggle to meet every individual’s requirements.

 

How can you invest ethically?
Investing ethically doesn’t have to be difficult thanks to robo-investors, like Wealthify, who let you choose between original and ethical investments and do all the hard work for you. With an actively managed ethical investment, you pay a little bit more than the original investment style but regular checks ensure that companies you’re invested in retain their high standards.

Alternatively, you could choose to go it alone and do the research, diving into ESG performance, and then buying, selling, and balancing your portfolio yourself. This is perfectly achievable, but it does require a lot of research and a good understanding of the ins and outs of investing and trading. And if you choose to not use funds, as they don’t meet all your ethical values, it could be a far more expensive venture.

 

Should I choose ESG or SRI investing?
If you’re aiming to invest ethically, and you don’t know what approach to take, then it could be a good idea to ask yourself what matters most to you – investment performance or social responsibility? If you think they’re equally as important, then that’s fine too.

Ultimately, the decision is up to you and will depend on your willingness to accept risk, adapt your ethical values, and the amount of time and research you’re happy to put in.  

 

References:

1: https://www.statista.com/statistics/422435/socially-responsible-investments-europe-sustainability-themed/

2: https://www.ussif.org/files/2018%20Infographic%20overview%20%281%29%281%29.pdf

3: https://corpgov.law.harvard.edu/2017/07/27/esg-reports-and-ratings-what-they-are-why-they-matter/

4: https://cris.maastrichtuniversity.nl/ws/portalfiles/portal/907808/guid-26fc9091-58bf-47b9-a87f-8549b5725443-ASSET1.0.pdf

5: Data from Bloomberg

6: https://www.worldbank.org/en/news/press-release/2018/10/29/seychelles-launches-worlds-first-sovereign-blue-bond

 

Past performance is not a reliable indicator of future results.

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

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