Impact Investing or ESG: What You Need to Know

In recent years, socially responsible investing has continued to gain in popularity. More and more investors are looking beyond the returns they can glean from their investments and considering the potential impacts of the companies they invest in.

In fact, the number of different methods used to invest responsibly has continued to blossom as professional investors seek a variety of different ways to measure the impact of their investments. Two of the most common forms of socially responsible investing are impact investing and ESG (environmental, social, and governance).

However, while there is some overlap between these two methods, there are some critical differences for investors to understand. Here's what you need to know about impact investing and ESG to decide which is better for your strategy and circumstances.

Similarities and differences between impact investing and ESG

Many investors use the terms "impact investing" and "ESG" interchangeably, and on the surface, it's easy to see why. Both involve screening investments for very specific factors — and the concept of doing well by doing good.

Additionally, there's no standard definition for either of these terms. As a result, a review of numerous websites on this topic will bring up a wide variety of different explanations about what impact investing and ESG are and how they differ.

However, investors can rely on some basic tenets to understand these two approaches to investing and decide which is right for them. For example, one of the more obvious differences is the exclusion of governance issues from impact investing, which focuses on social and environmental good.

Governance is more of an inward-looking, investor-friendly factor than social and environmental issues. In fact, companies with poor governance policies and practices can bring significant risk to investors — a factor that also offers some insight into another key difference between impact and ESG investing.

ESG as risk-mitigation strategy

For example, corporate structures that place all the power in the hands of founders or executives don't give investors any say in what the company does. As a result, insiders can do virtually anything they want with the company, and investors have no recourse — except to dump their shares, potentially at a loss.

The risks associated with governance issues provide clues and insight into how ESG investors traditionally have viewed this form of investing. A critical factor of ESG investing involves looking at the potential risks all three of those factors pose toward each company.

In fact, one could even argue that ESG is at its core a risk-mitigation investment strategy because investors evaluate the potential environmental, social and governance risks whenever considering a particular stock.

While impact investing focuses on investors doing good by investing only in certain companies or areas of the market, ESG looks at the potential negative impacts a company may face as a result of poor environmental, social or governance policies.

For example, a company that is a high polluter or otherwise just ignores the damage it does to the environment could face regulatory or legal backlash down the road. Alternatively, companies that don't treat their workers fairly could face a strike or some other social backlash.

In both scenarios, the negative results of these poor policies could wreak havoc on the companies' profits and stock prices down the road. On the other hand, positive ESG policies could present future opportunities for companies that stick with them.

Some other key differences between impact and ESG investing include:

• ESG tends to be backward-looking, while impact tends to be forward-looking.
• Numerous guidelines for measuring ESG factors and risk exist, but impact is less measurable and more of an ideal.
• ESG is restricted to very specific environmental, social and governance frameworks, but impact can include or exclude virtually any idea, depending on what areas an individual investor wants to have an impact on.
• ESG is largely an exclusion framework by which investors avoid companies with bad ESG scores. On the other hand, impact is essentially an inclusion factor through which investors look specifically for companies that are having a positive impact on any areas in which they want to do good.

Overlapping themes for impact and ESG

Amid all the similarities and differences in how impact and ESG investing are accomplished, there is significant overlap in the areas of focus. Here are some of the most interesting and impactful areas of focus that lie at the intersection of impact investing and ESG:

• Climate tech
• Clean tech
• Agri tech
• Healthcare
• Affordable housing
• Education
• Fintech

It's also important to realize that many companies outside these themes also qualify as either impact, ESG or both. For example, Amazon (AMZN) appears in many of the largest ESG funds, as it is making an effort to electrify its fleet and qualifies for ESG in other areas.

However, individual investors may prefer to focus their impact or ESG portfolios on companies that more clearly fall into one or more of the themes listed above. 

For example, Joshua Phillipson, an international investor-relations and corporate-communications professional, has led IR at a small, Nasdaq-listed, Israel-based pharmaceutical company for the last several years. He explains why a growing number of investors have come to see his company as an impact investment — even though they don’t have any formal ESG processes beyond those required and operate in many ways like a start-up. 

“I do find many of our investors are attracted to the company not only for its long-term financial potential but also for the positive impact potential,” Phillipson said. “For example, investing in the company provides an opportunity to be involved in developing exciting and innovative drugs that address significant health needs. Investors with family or emotional connections to Israel also appreciate the opportunity to actively support the local pharma industry.”

Impact and ESG performance

Many investors decide to allocate part of their portfolio to one or both of these approaches with the expectation of sacrificing returns in exchange for doing good with their investments. However, with careful stock-picking, both approaches do offer prospects of earning financial returns in addition to doing good. Thus, it's easy to see why impact and ESG investing have become so popular.

Unfortunately, tracking the performance of impact and ESG stocks is extremely challenging, although indexes like the S&P 500 ESG Index can offer a bit of insight. Through Jan. 10, the S&P index is up 24% over the last year and 46% since its inception in August 2020. For comparison, the S&P 500 is up 20% over the last 12 months and 25% over the last three years.

For impact stocks, it becomes virtually impossible to track the overall performance because investors can consider a wider variety of stocks to be impact names depending on what social or environmental areas they wish their investments to have a positive impact on.

However, we do know that investors are generally happy with the returns they're seeing on their impact portfolios. In 2023, the Global Impact Investing Network (GIIN) found thatnearly 80% of investors said their impact investing strategies have met or exceeded their expectations.

Additionally,the GIIN reported in 2023 that investor allocations to impact strategies have been steadily rising. As of the last check, 45% of U.S. and Canadian investors had allocated $198 billion worth of assets to impact strategies in their region alone. In 2022, the GIIN estimated that over 3,349 organizations were managing $1.164 trillion in impact investments.

Impact or ESG?

As investors consider impact and ESG approaches, they may want to consider a critical difference between them that explains why it might make sense to choose one over the other.

“Impact investing is more focused on the goal of the investment, while ESG represents an investing framework,” explained Daniel Naim, founder and CEO of Fennel Markets. “The impact investor wants to allocate capital in a way that promotes some sort of positive change in the world while seeking a positive ROI. Meanwhile, the ESG investor looks at specific pieces of information about a company and uses that to inform their investments.”

He also explained how this difference could enable investors to implement both.

“The ESG framework can be used to inform an impact investing strategy as a form of risk management or even as standard due diligence before making an investment,” Naim said.

At the end of the day, deciding whether impact or ESG is the better investing approach is a personal choice every investor should consider. There are advantages to both approaches, but one might be a better fit than the other, depending on your strategy and portfolio allocations.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.