One in five professionally managed dollars in the U.S. is now invested with environmental, social and governance (ESG) factors in mind, according to the latest data from the US SIF Foundation.  Its European counterpart Eurosif finds that more than half of assets in Europe can be categorized as “sustainable and responsible investments” (SRI). Investors managing more than $60 trillion have signed up to the UN-backed Principles for Responsible Investment (PRI).

Three impressive statistics, and three different acronyms. They cover a wide range of investment approaches, and cause considerable confusion in the marketplace.

So how should investors make sense of the responsible investment alphabet soup?

Part of the problem is that many of the acronyms and expressions used lack an agreed definition, and are often used casually or interchangeably. But sloshing within the soup are terms and approaches that have more precise meanings, and which can be used to understand the investment approach of a self-described responsible or ESG investor.

As a starting point, SRI, responsible investment, and ESG investing can be considered umbrella terms. Put simply, they involve some consideration of environmental, social, ethical and/or governance issues in the selection and management of investments and typically they imply a relatively long-term investment horizon.

Ethical Investment is a sub-set of responsible investment. The approach – avoiding companies whose activities conflict with an investor’s values – was born out of campaigns against apartheid in South Africa in the 1980s, and several religious groups also adopted a similar approach and pioneered the modern SRI industry.  For that reason, and because many retail SRI products still take an ethical investment approach, many people continue to conflate responsible investment or SRI with ethical investment.

However, the subjective nature of ethics, and an investment approach that involves excluding companies and often entire industry sectors makes this a niche pursuit. Ethical investors are commonly understood to be prepared to accept increased volatility and the risk of underperformance as a price worth paying to invest in line with their values.

ESG Integration
For most responsible investors, however, the starting point is that an understanding of ESG issues can help improve investment returns, by identifying risks and capturing opportunities that might be overlooked by the wider market.

Such an approach can be characterised as ESG integration (as opposed to the somewhat vaguer ‘ESG investing’). It involves investors incorporating a rigorous assessment of ESG factors with their existing financial analysis, with a view to generating outperformance.

This integration is the first of the six principles to which PRI signatories commit. There is, of course, a range of options as to how that ESG analysis is used to inform investment decisions.

One approach is best-in-class investing, where ESG scores are used to identify the top ESG performers in each industry sector. This has the advantage of allowing managers to construct portfolios that mirror the mix of industry sectors found in the wider market, preventing too much divergence in returns from market benchmarks.  One downside, however, is that best-in-class investing tends to focus on how a company is run, ignoring what it produces.

Incorporating ESG Risks And Opportunities
An alternative approach is instead to identify the providers of solutions to the pressing environmental problems we face as a result of population growth, changing demographics and increasing consumption. This approach could be categorised as thematic ESG investing, and it can be particularly successful when applied to under-researched mid- and small-cap companies.

Impact Investing
Another strategy, impact investing, is gaining traction as an allocation style, particularly within the wealth market, with investors seeking to align their investments with their values. The approach involves investing with a view to generating a measurable environmental or social outcome in addition to a financial return. While this approach has its roots in philanthropic and venture investing, it is increasingly being applied to "pure play" listed equities that deliver environmental or social solutions.

In Conclusion
So much for defining our terms. What does all this mean for investment performance? For ethical investing, the calculation is clear: restricting the size of the investible universe increases the volatility of returns compared with the broader market. For ESG integration, however, our experience and the emerging academic consensus is that investing responsibly need not sacrifice returns and, in the majority of cases, and particularly over the longer term, integrating ESG factors provides investors with additional information and insight, helping them to outperform.

Lisa Beauvilian is head of Impax’s Head of Sustainability & ESG.