Positive impact: should you swap ESG for other ethical alternatives?

There are growing doubts about the transparency and financial performance of ESG-rated investments. Could impact investing be a better bet?

The rapid rise of environmental, social and governance (ESG) investments should be viewed as a remarkable success. But amid the excitement, critics have cast doubts on the transparency and measurability of ESG, warning that some listed businesses may be abusing the label. 

Investors and consumers alike want businesses to do more about issues such as climate change, diversity and human rights abuses. The corporate world is responding. According to Bloomberg, money held in sustainable mutual funds and ESG-focused exchange-traded funds rose globally to $2.7tn (around £2.35tn) last year – up by 53%.

However, there are a range of concerns. For example, the ratings agencies that grade ESG performance tend to focus on a firm’s efforts to offset harms and risks linked to sustainability, rather than its actual products and services. This explains why electric carmaker Tesla was excluded in May from a list of the most socially responsible companies in America – the S&P 500 ESG Index – while the likes of Amazon and oil and gas giant ExxonMobil remained in place.

Focusing on impact is a neat way of avoiding some of the contradictions and disappointments that can ensue from ESG labels, which are far less prescribed

Ratings agencies also rely on ESG data provided by companies themselves to make their assessments, making it harder to avoid so-called ‘greenwashing’. Researchers at Columbia University and the London School of Economics recently compared the ESG records of US companies in 147 ESG fund portfolios with those in 2,428 non-ESG portfolios and found the former group had worse compliance records when it came to labour and environmental rules. 

Even the financial performance of ESG investments is being called into question, at a time when rising inflation and interest rates are rattling markets. Some investors are seeking alternative ways to invest ethically. 

Avoiding contradictions

One increasingly popular choice is ‘impact investing’. Unlike an ESG investment, where financial returns and risks take priority, impact investments first and foremost aim to produce a tangible and measurable social good. That could mean backing companies that are helping to roll out clean energy, sustainable agriculture or microfinance, or public services such as healthcare and education. 

“Impact investing means focusing your investments on companies and activities deemed to be actively solving the world’s problems,” says Becky O’Connor, head of pensions and savings at the investment platform Interactive Investor and author of The ESG Investing Handbook. “Focusing on impact is a neat way of avoiding some of the contradictions and disappointments that can ensue from ESG labels, which are far less prescribed.”

According to the Global Impact Investing Network (GIIN), a US non-profit advocacy group, impact investing offers an effective alternative to philanthropy and can be deployed in both emerging and developed markets. Investments are expected to make a return, but these will vary depending on an investor’s goals. According to a 2020 survey, GIIN found 67% of respondents were targeting risk-adjusted market-rate returns, 18% were content with below market-rate returns, and 15% expected something closer to capital preservation. 

Yet the market, while growing, remains small. At the end of 2019, GIIN estimated that around 1,720 organisations globally had about $715bn of impact-type investments under management.

Big players 

This may change as big players dip their toes into the impact market. In 2020, the global asset manager Schroders partnered with Big Society Capital, one of the UK’s leading impact investors, to launch the Schroder BSC Social Impact Trust (SBSI). This London-listed fund invests in firms tackling “pressing social problems” and aims to achieve a sustainable return. 

“We are targeting the deepest level of impact and find organisations who use all their resources to contribute to solutions to social challenges such as homelessness, mental health, unemployment and fuel poverty,” says Andrew Beal, managing director of investor engagement at Big Society Capital.

About two-thirds of the trust’s investments are linked to inflation, he says, and it is targeting returns equivalent to CPI plus 2% once it is fully invested over three to five years. “The trust’s investments are largely uncorrelated to mainstream markets so we would expect the portfolio to show resilience in times of market volatility,” Beale adds. 

Another well-known impact investor is Nesta Group, which was set up by the government but now operates as an independent charity. It targets private equity-style investments in areas such as ed tech, food tech and climate tech, investing both from its endowment and on behalf of private investors.

Lisa Barclay, its executive director of investments, says a wave of impact funds have launched over the last few years thanks in part to the “mainstreaming of ESG”. But while impact isn’t higher risk than other asset classes, she says, it does come with “a different sort of risk” and won’t be for everyone. 

“We do expect impact investment to grow, but it will likely remain a relatively niche investment strategy.” 

In truth, the market’s challenges are many. Impact investors are under greater pressure to report and measure the social and environmental performance of their investments, which can be complex. Some complain of a lack of suitable exit options for impact investments, a shared definition of what constitutes an impact investment, relevant professionals with the right skills to manage these assets, and research on market trends, practices and performance. 

“The pool of investments that match true impact criteria is of course narrower [than ESG], so this can mean it is harder to diversify, which is one of the golden rules of investing,” O’Connor says. “However, if you are committed to planetary betterment and you want all of your money to be too, this may be a risk you are willing to take.”

ESG battles on

Glen Yelton is head of ESG client strategy for North America and EMEA at the fund manager Invesco. He agrees that impact strategies are “only truly actionable in a limited number of asset classes and markets”, even if impact investing often has a “clarity to it” that other categories of ESG investing may lack. 

Eoin Murray, head of investment at the fund Federated Hermes, says that no one form of sustainable investing is better than the other; it very much depends on what clients want to achieve. 

“Impact can be made through engagement and investing in companies that are capable of additional transformation, whereas integrating ESG will be sufficient for others and is equally capable of playing a role in the necessary transition.” He accepts that ESG as a concept is facing a backlash as firms jump on the bandwagon, but he thinks there will be a shakeout that leaves the industry “in a far better place”.

In truth, every type of ethical investment strategy comes with trade-offs, and professionals must be honest about this. But experts warn that a lack of clarity over terms and labels in the industry can lead to disappointment. 

City regulator the Financial Conduct Authority is looking into sustainable fund labelling and will publish a consultation paper in September. It hopes to categorise funds and make more explicit options available to investors, including impact. Until then, those who wish to put their money to work responsibly would be wise to do their own research thoroughly.