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If you want your investments to align with your values, then you may be considering an approach that incorporates impact investing or environmental, social and governance (ESG) investing. These two terms are sometimes used interchangeably, and there are similarities to these approaches to value-based investing. However, there are also meaningful differences that separate the two.
ESG vs. Impact Investing
Although definitions can vary, here's a helpful way of thinking about ESG versus impact investing:
- Environmental, social and governance (ESG) investing: Investors and advisors use ESG ratings to evaluate companies based on how they're run and how they've performed in the past. They might exclude companies from their portfolio based on the results.
- Impact investing: Investors invest in companies that they believe will create a positive and measurable social or environmental change.
Put another way, ESG ratings allow investors to refine their investment choices based on the ratings and their morals. However, the primary goal is to earn as much money as possible while sticking to ESG values and the investor's risk tolerance.
In contrast, impact investors choose to invest in companies that will create a positive change in the future. That doesn't mean impact investors don't earn money—it's just that the earnings aren't the only focus. Instead, impact investors might reference a "double bottom line," the earnings and the impact are both important measures of success.
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How Are ESG and Impact Investing Similar?
Although there are big differences between ESG and impact investing, both approaches share a few commonalities.
- They offer an ethical lens for investing. Investing in ESG funds, creating an ESG-based portfolio and becoming an impact investor are all ways to align your investments with larger goals or values.
- They cover different types of impact. ESG investing might focus on companies that do well within one or several of the areas: environment, social impact or corporate governance. Similarly, impact investors might be looking to create a change within housing, education, health care, climate change or other areas of need.
- They involve taking on risk. Every investment comes with a risk of losing money, and ESG and impact investing are no different. Neither are measures of risk—there can be very risky and relatively safe investments that meet an investor's ESG or impact investing goals.
How Are They Different?
Although there are some similarities, ESG and impact investing are also fundamentally different in a few ways:
- ESG offers an alternative way to create traditional portfolios. A financial advisor might use ESG ratings as criteria to help you create and manage your investment portfolio. However, they tend to choose from the same set of traditional investment options, minus the ones that don't meet your ESG criteria.
- ESG ratings tend to be for public companies. There are many ESG rating systems, and most focus on rating publicly traded companies. In contrast, impact investments tend to be in private companies. As a result, some impact investments are only available to accredited investors—wealthy individuals and financial professionals.
- Impact investing doesn't put profit first. Impact investors generally aim to make money or break even with their investment—they may occasionally invest knowing that they would likely make more money elsewhere. Additionally, one of the main goals is that the investment will create measurable change.
- Impact investing tends to focus on future impact. With the above in mind, ESG tends to look back and use a set of criteria to exclude companies from a portfolio. Impact investing looks for opportunities to invest in companies that will create or further a change, including startups that don't have a track record.
Pros and Cons of ESG and Impact Investing
Impact investing and ESG can overlap in many ways, and they share a few pros and cons. For example, you can feel good about your investments reflecting your values, but you may also potentially take on additional risk if you don't diversify your holdings.
There are also a few distinct pros and cons to consider.
| Pros and Cons of ESG and Impact Investing | |||
|---|---|---|---|
| Environmental, Social and Governance (ESG) | Impact Investing | ||
| Pros | Cons | Pros | Cons |
| Can be useful for screening companies and investments | A high ESG score in one area doesn't necessarily mean the company meets your other criteria | Recognizes that impact can be as important as profit to investors | Some investments are only available to accredited investors |
| There may be ESG funds within your 401(k) or IRA | ESG scores don't necessarily reflect the impact of a company's products or services | Can help create important changes and demonstrate the viability of these types of investments | Investing in early stage companies tends to be riskier |
How to Choose Between ESG and Impact Investing
Rather than choosing one or the other, ESG and impact investing can be complementary approaches for putting your money to work.
For example, you might invest within your employer-sponsored retirement plans, such as 401(k)s. With these types of plans, you often have to choose from a limited list of mutual funds and exchange-traded funds, which might include several ESG or impact investing funds.
Research the funds' goals and holdings to see if they align with your values, and you can start putting your retirement savings to work. You can also invest in ESG and impact investing funds within a brokerage account, IRA or HSA.
If this is an area of interest, you can also hire a financial advisor who specializes in socially responsible and ethical investing to help you identify appropriate investments. Impact investing might lead to a lower return on investment, and an advisor could also help explain how this could impact your finances.
The Bottom Line
You can use ESG and impact investing to try to earn money while furthering causes that you care about. For many investors, it may be easiest to start with ESG investing, but you can also research impact investing options, including ones that don't require accredited investor status. No matter which path you choose, know that investing can be risky, but it's also often an important part of building wealth.
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