Contrary to what many may think, ESG (environmental, social and governance) is not an investment strategy. Rather, it’s a data tool. While many investors use ESG data to capture a set of values around which an investment strategy may be organized, it is most commonly used by institutional investors to detect material risks and opportunities associated with potential investments.

The ESG shorthand has become ubiquitous and is turning up in mutual funds, exchange-traded funds, separate accounts and in various investment mandates. Yet its exact meaning remains elusive. ESG is often associated with socially responsible investing (SRI), an investment strategy where securities are chosen based on their moral or ethical value to the investor. Products built along these lines can be both inclusionary and exclusionary.

It is important to note that while ESG and SRI approaches are often lumped together in the overall “responsible investing” discussion, they are not one-and-the-same. SRI-focused approaches may incorporate little to no ESG-based data or analysis in their approach. Such distinctions may sound like hair splitting, but if an investor is looking to add exposure to an ESG-driven approach, looking under the hood is key to make sure a manager or an index is truly leveraging the latest in ESG data, not just a subjective approach to social responsibility.

The distinction matters since over the past few years mutual funds and ETFs have been developed around themes that include religious values, global warming, and diversity, among many others. Other funds are designed to actively exclude companies based on various grounds, including those involved with tobacco products, guns, or nuclear power. SRI can mean different things to different people, and this is reflected in the varying criteria built into SRI funds. 

But ESG in a fund name or product description, by contrast, does not automatically imply the exclusion of specific companies or sectors. In a true ESG approach, ESG data is integrated into the investment process as a supplement to traditional financial analysis, and becomes a further factor in weighing securities for potential inclusion in a portfolio. It is not exclusionary by nature, though it may have that effect as a result of how ESG data is integrated into portfolio decision-making.

The current definition of ESG is generally taken from two major standards groups—the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB)—which arose to identify and codify good corporate reporting practices. ESG is designed to measure how a company does business, identifying potential social and ethical issues, and quantifying the impact on corporate performance for disclosure purposes. This data can be applied in any number of ways by investors, advisors and asset managers creating investment products for the marketplace.

In practice, these products vary widely in their investment objectives, with some emphasizing the environment, some religion, and others gender diversity, to name just three possible themes. This lack of consensus around the responsible investing concept has led to increased confusion among investors. A recent survey conducted by CAIA, a global association for the alternative asset industry, and the private equity firm Adveq, found that institutional investors overwhelmingly believed that ESG is an important element in the investing process.  At the same time, more than 4 out of 5 of those surveyed said that the industry lacked clear standards as to what constituted a socially responsible investment, and that the lack of standards was impeding the category’s growth.

As a data tool, ESG stands outside the “values” debate.  As GRI’s guidelines for corporate reporting note: ESG information including data and performance metrics are inexorably intertwined with other company metrics and should be evaluated in an integrated fashion to determine why a company “will succeed.” 

SASB notes that its sustainability standards were developed in accordance with the definition of “materiality” as established by federal securities laws. 

For both organizations, ESG criteria are designed to measure how a company does business, identifying a raft of ethical issues and standardizing how businesses can quantify their performance for disclosure. 

This is consistent with the approach advocated through the Principles for Responsible Investment (PRI), considered the foremost guide in the implementation of ESG information to investment strategies. More than 1,500 organizations with over $60 trillion in AUM have signed onto the PRI’s “Six Principles.” The stated goal of the organization is to encourage the “incorporation of ESG standards into investment decisions, to better manage risk and generate sustainable, long-term returns.” It pointedly notes that ESG investing “does not require ruling out investment in any sector or company. It simply involves including ESG information as part of investment decision-making, to ensure that all relevant factors are accounted for when assessing risk and return.”

ESG data can be used to construct portfolios reflecting whatever set of concerns are given priority by the investor, the advisor, or the portfolio manager.  Strategies include identifying best in class companies or sectors; excluding lower rated companies; sustainability themed investing; or simply integrating ESG data and analysis into traditional financial analysis.  In alternative funds, ESG is increasingly finding its way into strategies focused on shareholder activism, and impact investing.

Clearly, responsible investing is more than a passing fad. The CAIA survey found that 77 percent of respondents thought that responsible investing had grown in significance in the prior three years, and a like number thought it would be even more significant three years from now. The keys to growth: industry standards and investment performance, among other factors.  An important first step in establishing standards will be to better clarify the key differences between ESG and SRI, so investors will be better educated and able to drill down into the approaches of each of these new funds and approaches coming to market.  

Ben Webster is the CEO of OWLshares, a provider of research, analytics and index creation services focused on environmental, social and governance (ESG) data.