For many investors, the promise of ESG (environmental, social and governance) investing has been elusive and confusion around the term has led many investors to be disappointed with their portfolios.

So, what is “ESG investing”? Is this the same as ethical, responsible or green investing? The simple answer is “no”.

Unfortunately, many industry players as well as academics and investors use these terms interchangeably. These are, depending on your point of view, very different things.

For retail investors, these terms tend to revolve around the concept of a “good” portfolio that doesn’t hold companies that are “doing bad things.” It goes without saying that the definition of “bad things” differs from one investor to another.

Does this only include landmines and tobacco? Or does it extend to broader “sin stocks” like gambling, pornography, and alcohol? Is coal mining bad? Or is all mining bad? Is coal-fired power generation on the “bad” list? And uranium? Does a tobacco exclusion include the company that makes the cigarette packaging or the supermarket that sells them in its stores?

All of these considerations generally fall under a portfolio’s exclusion list. i.e. what is prohibited in the wallet. There are more complex considerations such as materiality levels and supply chains, but the core of investors’ expectations is usually what they don’t want to see in their investment portfolios.

Given the issues of quality and transparency of company data, the specificity of materiality levels and details of supply chains up and down the value chain and the active role played by regulators to protect against against perceived greenwashing, many investment managers are finding it increasingly relevant.
“strict exclusions” are a risky business proposition.

Although some products, generally (but not always) described as ethical, contain these exclusions, this is not what the majority of institutional investors consider “ESG integration”. Following the creation and global adoption of the United Nations Principles for Responsible Investment (UNPRI), the definition of responsible investment and ESG investing has taken an important turn.

The UNPRI effectively defines the integration of ESG factors into investment decisions as the key action determining responsible investment. Principle 1 states “We will integrate ESG issues into investment analysis and decision-making processes.”

It says nothing about how to incorporate these issues, nor does it require investors to take specific actions regarding them. This is why investment managers are willing to “integrate ESG” in any way that suits their investment process.

Therefore, it is crucial that advisors and investors recognize these differences, as failure to do so not only blurs the discourse on sustainable finance, but can also lead to ineffective investment strategies.

To help investors more easily allocate capital to support their views, Lonsec Research has identified four key responsible investment (RI) styles: ethics, ESG integration, sustainability and impact.

Although managers may have a primary RI style and integrate ESG into their investment process, it is the RI style that should be used to determine the primary direction of the strategy.

Ethical investment

A values-driven approach in which investors choose companies based on their personal moral compass. This may include avoiding industries like tobacco, alcohol, or weapons, regardless of the company’s financial performance or environmental footprint. It’s very subjective and what is ethical for one person may not be ethical for another. Ethical investors tend to focus on alignment with their beliefs rather than a specific framework.

ESG investing

This takes a more systematic approach, integrating environmental, social and governance factors into investment decisions in a variety of ways. Investors can integrate ESG factors to varying degrees, from simply selecting companies with poor ESG performance to actively selecting those that excel in sustainability or governance.

Some investors may focus on specific issues, such as gender equality or reducing carbon emissions, while others look for companies that balance strong ESG practices with strong financial returns. The most common approach is where investors consider ESG risks, as well as all risks, and ensure that the expected return on the stock or bond adequately compensates for that risk.

There are also strategies that prioritize shareholder engagement, using the power of ownership to push companies toward better ESG performance. Whether exclusion screens, positive screening or active engagement, ESG investing offers a flexible framework that allows investors to address a broad range of concerns, while aiming for positive financial performance at long term. ESG investing aims to balance financial return with mitigation of sustainability and corporate governance risks, often serving as a benchmark for responsible capitalism.

Green investment

This approach focuses on environmental impact. Investors in this space are prioritizing companies that are leaders in areas such as renewable energy, sustainable agriculture or reducing carbon emissions. Although green investing is a subset of ESG, it does not take into account broader social or governance aspects. For example, a company may be a leader in reducing emissions but fail miserably in terms of labor practices or board diversity.

The confusion of these approaches dilutes the progress each seeks to achieve, and it is essential that financial advisors and their clients understand these distinctions. Ethical investing is about aligning investments with personal values, ESG is about assessing overall risk, and green investing is purely environmentally focused. Clarifying these definitions allows investors to make better choices, leading to real change in their areas of interest.

Tony Adams is Head of Sustainable Investing Research at Lonsec Research.