Child labour, high drug prices, weapons manufacturing and damaging the environment are all business actions that evoke a wide array of emotions. As people find new ways to communicate and voice their views, the actions of businesses and industries are scrutinized more than ever before. No longer are investors expressing their views only through social media; they are taking action through their investment decisions.

The behavioural side of investing isn’t a new concept, but moral and values-based investing is a burgeoning trend, giving rise to a new wave of investor demand. So what is sustainable or ethical investing? The number of monikers used to describe sustainable, socially responsible, ethical investing and environment, social and governance (ESG) excellence are wide ranging, used interchangeably and can be confusing.

Looking under the hood of ethical investing

In the early days, ethical investing centred around negative screening that simply excluded sin stocks such as tobacco, gambling, alcohol and gun manufacturing companies. Because negative screening didn’t always produce positive results, a more sophisticated process was developed and socially responsible investing (SRI) emerged.

During the early 2000s thematic investing increased as green technology boomed, later giving birth to what we now know as ESG integration. Responsible investing is the broader term used to describe this spectrum of investing.

Skirting the edges of the mainstream, the spectrum of responsible investing is muddied by mixing the labels defining ESG integration, ethical and socially responsible investing. The challenge for investors is determining an appropriate strategy that can align their values with their investment decisions.

For some, this decision is similar to choosing between organic or all natural foods; where organic is more stringently defined and regulated, all natural foods are defined by a looser interpretation. The confusion for many investors lies in the various definitions of what’s often marketed as socially responsible investing.

Distinguishing between “environment, social, governance” and “socially responsible investing”

ESG integration

Screening investments for environment, social and governance factors and integrating this criteria into the investment management process is known as ESG integration. Integration is an inclusionary process where every sector is considered versus the exclusionary process used in ethical or socially responsible investing.

• Environmental factors screen investments that consider environmental risks and the scarcity of natural resources.
• Social factors include labour ethics, supply chain and product safety considerations.
• Governance factors cover how a business is run, executive pay and shareholder rights.​

Selecting companies for an ESG fund requires additional decisions that traditional investing may not consider. Because of this, two ESG funds can contain different holdings as each fund may weigh environmental, social and governance factors very differently. For example, both an integrated energy company and a pharmaceutical company may rank highly on ESG screens, but for completely opposite reasons - one may favour land reclamation policies and the other contributes to the treatment of infectious diseases. However, neither of these companies’ activities may align with the negative screens in place for ethical or socially responsible investing.

Socially responsible investing

“Morningstar defines SRI as funds making investment decisions based on meeting constraints such as environmental responsibility, human rights or religious views”. SRI screening has historically excluded “sin” stocks; however, constraining or excluding investment choices limits the opportunities for investors and may impact the effectiveness of their portfolio. For some investors, these exclusions may not go far enough and may require additional constraints to meet religious views. For example, green bonds, a form of debt issued to fund a project with societal impact, may meet the environmental responsibility standard but fail to meet certain religious constraints due to its debt nature. The broad definition of SRI requires investors to have strict in-practice approaches to align an investment’s suitability to an investor’s values.

Funds often marketed as SRI may in truth, be more ESG focused thus requiring investors to do their homework. So where does an investor draw the line in terms of social responsibility? An SRI fund would likely not be invested directly in a liquor store chain, but the fund could have indirect exposure through real estate in a real estate investment trust (REIT). By leasing retail space to liquor stores, the REIT would indirectly profit from the sale of alcohol, leading to questions of whether holding the REIT violates an investors view on SRI.

Applied excessively, SRI can quickly become unworkable in a world in which businesses and individuals interact with each other in myriad ways. SRI funds often have greater exposure to certain sectors and countries, ultimately reducing the amount of diversification within a portfolio.

Investing in social impact

Constructing an investment portfolio with some form of social impact at the same time it grows your nest egg appears to be a perfect match. But, the challenge is distinguishing between the marketing of SRI and ESG strategies and applying values in a manner that is agreeable to all potential investors.

As the old saying goes, always look under the hood before you buy a car and investing is no different. We advocate having a well-defined investment process that identifies value creating companies, because value creating companies often have stronger governance structures, operational excellence and better risk mitigation strategies to cope with shocks to the business. The trick with socially responsible investing is determining what your criteria are for creating a positive impact.