A crowded field of labels

Ethical investing, sustainable investing, ESG (environmental, social and governance) investing, SRI (socially responsible investing), and impact investing are all terms used, sometimes loosely and sometimes interchangeably, to describe funds that take non-financial factors into account alongside financial returns. Despite the shared language, these labels can mean quite different things depending on the fund provider, and it is worth understanding the distinctions before assuming a fund matches your personal values.

Negative screening versus positive and impact investing

Negative (or exclusionary) screening

This is the oldest and simplest approach: a fund simply excludes certain sectors or companies, commonly tobacco, weapons manufacturing, gambling, or fossil fuel extraction, and then invests fairly broadly across everything else. A fund using only negative screening may still hold large, well-known companies that some investors would not necessarily think of as "ethical," as long as they do not fall into an excluded category.

Positive and best-in-class screening

Some funds go further by actively favouring companies that score well on ESG metrics relative to their industry peers, rather than simply excluding a list of sectors. This can mean holding companies in sectors like oil and gas or mining, provided they are considered relatively better performers on environmental or governance measures than their competitors, which can surprise investors expecting a more purist approach.

Impact investing

Impact investing goes a step further still, seeking investments specifically chosen for the measurable positive social or environmental outcome they aim to produce, alongside a financial return, such as funds investing directly in renewable energy infrastructure or affordable housing projects.

Greenwashing and the FCA's Sustainability Disclosure Requirements

Because "ESG" and "sustainable" carry no fixed legal meaning on their own, some funds have historically been criticised for overstating their green or ethical credentials relative to what they actually hold, a practice commonly called greenwashing. To address this, the Financial Conduct Authority introduced the Sustainability Disclosure Requirements (SDR) and an associated labelling regime for UK-based investment funds. Under this framework, funds that want to use a sustainability-related label must meet specific criteria and disclosure standards, giving investors a somewhat more standardised way to compare claims. Funds that do not qualify for a label, or choose not to seek one, must avoid certain sustainability-related terms in their naming and marketing. This is a welcome step towards transparency, but it remains important for investors to do their own checking rather than relying purely on a fund's name or marketing.

Look under the bonnet: check the actual holdings

Whatever label a fund uses, it is worth looking at its factsheet or key information document to see its top holdings and sector breakdown. Fund providers are required to publish this information, and it is usually available on the provider's own website or through your investment platform. If a fund's actual holdings do not align with what you expected from its name or marketing, that is worth investigating further, or raising directly with the provider.

Balancing values, diversification and cost

A narrower ethical or ESG remit inevitably means excluding some companies and sectors from your portfolio, which can reduce diversification compared with a fund that invests across the whole market. Whether this affects long-term returns is debated and varies by time period and fund; some ESG-focused funds have performed comparably to, or even better than, conventional equivalents over certain periods, while others have lagged, particularly during periods when excluded sectors such as energy have performed strongly. There is no permanent, guaranteed relationship in either direction.

It is also worth checking costs specifically: ESG and ethical funds, particularly actively managed ones, can carry a higher ongoing charges figure (OCF) than a plain low-cost global tracker, reflecting the additional research and screening involved. A higher charge compounds over decades, so weigh the cost against how strongly you feel about the fund's specific approach.

Key takeaways

  • ESG, ethical, sustainable and impact investing are related but distinct approaches, ranging from simply excluding certain sectors to actively targeting positive outcomes.
  • The FCA's Sustainability Disclosure Requirements labelling regime aims to reduce greenwashing by setting standards for funds that use sustainability-related labels.
  • Always check a fund's actual top holdings and sector breakdown rather than relying solely on its name or marketing.
  • A narrower investment universe can affect diversification and returns in either direction depending on market conditions.
  • Compare ongoing charges carefully, since ESG and ethical funds can cost more than equivalent broad market trackers.