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Ethical vs Impact Investing

11 January 2018

Investors seeking to make a positive contribution to the society or environment have several options. Here, we consider how ethical and impact investing differ.

The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • When the first ethical fund was launched.
  • What ethical investing is.
  • How it differs from impact investing.

Appetite for investing responsibly, or more actively with the aim of making a positive social or environmental contribution, is growing.

According to responsible investment rating and research agency Vigeo Eiris, the Socially Responsive Investment (SRI) European fund market grew from €135bn in 2015, to €158bn by the end of 2016.1

More significantly, the Global Sustainable Investment Alliance (GSIA), estimates that global sustainable investment assets reached $22.89 trillion in 2016, a 25% increase from 2014. 2 Furthermore, GSIA notes that Europe accounts for 53% of such assets, and estimates that more than 20% of the funds under professional management in America alone now incorporate some elements of responsible investment criteria, up from 9% in 2012.3

Despite this, the labels and terms used for this type of investment approach can be very confusing. Here, we consider the differences between ethical and impact investing.

In both cases, remember that with any investment the value of your capital can go down as well as up, and you might get back less than you originally invested.

Ethical investing

If you want to invest “ethically”, you would apply a particular set of values or beliefs that are personal to you to establish what is acceptable for your investments. These could come from your religious beliefs, personal views, or broad social values, such as human rights.

In practice, ethical investing tends to involve avoiding certain sectors and stocks while you search for investment returns, through an investment process called negative screening. This involves creating an investment policy with very specific rules aimed at avoiding companies or industries that don’t meet the criteria.

Charities use this approach both to avoid investing in industries which conflict directly with their mission statements or those where holding companies could be detrimental to their reputation.

Many investors that take this approach want to completely avoid certain companies, sectors or countries. Arms, tobacco, pornography and gambling, otherwise known as ‘sin stocks’, tend to be the first holdings negatively screened using an ethical investing approach. Other investors however, set a threshold before an exclusion is applied - for example, if more than 10% of a company’s revenue comes from one of these sectors, the company would be excluded from the portfolio.

Ethical investing can be a useful and direct way for investors to express their social or environmental preferences. Also, using a pre-specified list of prohibited investments makes it easy to understand what will not be in the portfolio.

At the same time, it can be a blunt and mechanical approach that appears simple, but can be tricky to implement as what’s ethical for one person may not be for another. This becomes clear where there are widely different views on a topic - for example, abortion, genetically modified foods (GMO), and nuclear power.

When choosing “ethical” funds, it can be difficult to know what is, or isn’t, in the portfolio because different funds take different approaches to what and how they screen.

The first ethical fund was launched in 1985, and many more funds have launched with a wide range of different objectives. If you find one that represents your views, it may offer a relatively simple and transparent way to align your investments to your beliefs.

Impact investing

Impact investing is a different and more nuanced approach. It examines the social and/ or environmental impact that companies are creating to help to decide whether to invest into them.

By undertaking impact investing, you would consider the net positive outcomes (impact) being made by the investment alongside its potential financial returns when making investment decisions. In practice, this means reviewing the company’s operating practices and/ or picking companies that are trying to solve social and environmental challenges. Also, using an impact approach tends to rely on companies’ impact evidence (the data), rather than personal beliefs to make investment decisions.

Impact investing recognises that the activities of many companies aren’t necessarily always wholly good or bad. Some impact funds hold investments that aim to make a positive impact but could be considered controversial. So, for example, a fund might invest in an energy company, if the investment allows the fund managers to use their voice as a shareholder to influence the management to change their approach to sustainability, human capital and governance. This may even include ensuring they have a long term focus which could lead them to shift from traditional energy sources (carbon intensive) to renewables.

Impact investments also measure and report on the impact they have generated to provide transparency for investors. This reporting also differentiates it from most ethical investing.

In either case, if you are unsure where to invest, consider taking professional financial advice.

No matter whether you invest without regard to social outcomes, through ethical or impact investing, please bear in mind you can still lose money.

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