Among the different strategies that investors use to build and diversify their portfolios, sustainable investing is causing the most ripples in the space. This emerging trend is revolutionising the way businesses and investors approach investments. It is also urging organisations to adopt a more sustainable approach to their business operations.
While it is heralding a positive social change, the best part yet is that the approach seems to be benefiting investors financially too. Statistics in a report suggest that the global sustainable investing assets will cross $50 trillion by 2025.
An increasing emphasis on this aspect of investing makes it important for us to understand it in detail. Let us delve deeper into what it means to invest sustainably.
Decades ago, John Wesley, founder of the Methodist movement, termed stocks that invest in gambling, weapons, tobacco, alcohol, etc., as ‘sin stocks’, and urged his followers to not invest in them.
In the first instance, this approach may seem foolish to you. But think about it, your investment is nurturing these companies. Isn’t it a good way to make the world a better place by refusing to invest in unethical brands and products?
Sustainable investing involves a thorough assessment of the environmental, social, and corporate governance aspects of an organization. Your investment decision shall then majorly depend on these aspects because the goal is to create a positive social impact. Fulfilling corporate social responsibility and realizing long-term financial gains are also the intended outcomes of such a strategy from the company’s point of view. It is also often termed the values-based investing approach.
There are three main strategies under the values-based investing approach. They are:
- ESG investing
- Socially responsible investing (SRI)
- Impact investing
ESG is an abbreviation for environmental, social, and governance aspects related to any investment. These ESG factors are considered besides the conventional financial analysis tools. The goal of the exercise is to assess risks and opportunities beyond those found in technical assessments. This approach has some social consciousness associated, but the primary focus is profitability.
To get more details on ESG funds, read our article on what are ESG Funds And How To Invest In The Best One on the Teji Mandi blog.
In this article, our focus is on the other two elements of the values-based investing approach, namely, impact investing and socially responsible investing. These terms are often confused with each other or used interchangeably. This article is aimed at helping you understand how the two forms of investing differ from each other.
Let us start by understanding what socially responsible investing is.
While ESG just considers the aspects and their possible impact on returns, socially responsible investing is more stringent. As an investor inclined towards socially responsible investing, you will eliminate or select investments based on how they hold up against your values and beliefs.
Suppose a mutual fund has been offering consistent returns of 10% since inception, but it invests in a company engaged in the production of alcohol. If you are against alcohol consumption, you may eliminate this company based on conflicting beliefs, irrespective of the return it fetches. You may, on the other hand, choose to invest in a company that shares the same value system as you. You may also focus on those organizations that contribute to charity, respond responsibly to calamities, and are up to the mark with their CSR goal.
Some associations that put off socially responsible investors include those engaged in the manufacturing of addictive (and harmful) substances, promotion of gambling, and production of firearms. These are never the choice of the investors who use this approach. Other major factors that can work against the company’s favor are their lack of environmental consciousness and indifference towards human rights.
The next question that arises is regarding the importance of financial returns and profitability in socially responsible investing. Are they still relevant? Of course, they are. After all, the underlying purpose of investing remains building your wealth. Despite how important the returns and profits are, they must not compromise on your principles. The idea is to strike a balance between getting good returns and maintaining the core values that are non-negotiable for you.
When socially responsible investing was introduced in public markets, investors could choose SRI mutual funds. These funds use the elimination approach to filter investments with negative social or environmental associations. However, when they first started, investors weren’t as particular about values-based investing and took the liberty to design their portfolios the way they wanted. A lot has changed now, and investors are prioritising their values to create conscious portfolios. However, it is still a finance-first investment strategy that uses a mix of financial instruments based on the type of venture and investor expectations.
Investors who follow SRI mostly look for long-term opportunities that offer good financial performance and have a low risk of a tainted reputation.
- Venture philanthropy: This is applicable for investors who wish to bring about a positive change and are open to investing in less structured organisations. The investment goes towards building and nurturing businesses.
- Outcome-based investments: Here, the investors choose organisations that are already creating value and invest in them based on past performance and reputation.
Let us now have a look at impact investing.
The concept of impact investing emphasizes on positive outcomes. So, investors who follow this approach invest only in companies that create a significant positive impact. For instance, if you are passionate about reversing the effects of climate change, you may invest in a company involved in recycling, planting trees, or researching and developing environmentally friendly alternatives.
However, if you come across an organization with a potential for offering promising returns but is involved in the unethical extraction of palm oil, as an impact investor, you’d overlook the returns and stay away from that company. This concept is often referred to as the ‘double bottom line’ concept and is used in impact investing. It means that it is quintessential to measure both the financial as well as the impact aspects and to report them.
Impact investing isn’t devoid of challenges and most investors find it difficult to track impact. There is also a haze around the exact definition and classification of positive impact. Thus, the expectations and assessment metrics vary from investor to investor, based on their unique goals and perceptions.
Most impact investors avidly look for investment models where profit and impact are correlated. Some benefits of impact investing include cash flow to new economic areas, projects with long-term profit potential, and negligible risk in terms of reputation and societal acceptance. In recent times, debt funds have become a popular investment tool among impact investors, whereas traditionally, impact investments were made only through VC and closed-ended PE funds.
With this, you may now have a good idea of the concepts of impact investing and socially responsible investing. Let us now see how the two differ.
The primary difference between impact investing and socially responsible investing. Impact investing focuses on the positive impact that a company aims to create, and investors put in their funds towards the securities of that company only if it is impactful as per their perception. On the other hand, socially responsible investing just filters the organisations that are associated with negative attributes.
Apart from this, impact investing is mostly carried out in private markets, whereas socially responsible investing applies to publicly traded vehicles.
These features differentiate the two concepts that come under the category of sustainable investment.
In conclusion: Let your personal choices define your investment decisions
Human activities and environmental abuse have long impacted the world, and finally, we have a generation of conscious investors who wish to create value with their money. If you are one of them, let your personal preferences and return expectations define how you wish to create an impact.
Every entity, be it a company or an individual, has the potential to bring about change. You just need to be clear about your sustainable development goals and reflect them in your investment strategy.