What is impact investing? Definition, examples and how to get started

The traditional investment model often prioritizes financial returns above all else. However, a growing number of investors recognize their money can be a force for good, too.

Impact investing is a strategy that aims to generate both financial returns and positive social or environmental change. Impact investing aims to support certain companies while also netting a profit for investor portfolios.

Here’s everything you need to know about impact investing, including some ways to get started.

Impact investing explained

At its core, impact investing involves buying shares of companies or funds with the intention of generating a measurable social or environmental benefit. Another aspect of impact investing is deliberately avoiding, or divesting, from specific companies that don’t align with certain moral or ethical standards.

Impact investing is a growing area of interest for investors. A strong majority of global individual investors (77 percent) are interested in investments that deliver both financial returns and positive social or environmental impact, according to a 2024 Morgan Stanley survey.

However, it’s unclear how effective impact investing is in achieving one of its main goals — driving change by shifting investment dollars away from companies with harmful practices. A 2021 study by Stanford University researchers showed that divestment has minimal impact on targeted companies’ cost of capital (the price they pay for investment). Why? In part because socially conscious investors still represent a small portion of the overall market (about 2 percent).

The Stanford analysis found that achieving a significant impact on a company’s cost of capital through divestment would require an unrealistically high level of participation by socially conscious investors — over 80 percent of all investable wealth.

Unlike traditional philanthropy, impact investors expect a financial return on their contribution. Individual values drive impact investing goals. Some investors align their portfolios with religious beliefs, while others respond to current events or environmental issues. Regardless of your motivations, you can find impact investments that resonate with your values.

Types of impact investing

Terms like socially responsible investing, impact investing, ESG, green stocks and sustainable investing often overlap. At their core, they all represent the idea of using investments to drive positive change in the world.

Environmental, social and governance (ESG)

ESG investing considers environmental, social and governance factors when making investment decisions.

This involves screening companies based on their performance in these areas and potentially excluding those with poor records.

ESG investing considers three key factors:

• Environmental: A company’s impact on the environment, such as energy use, waste management and resource consumption.
• Social: This focuses on a company’s relationships with employees, customers and communities, considering factors like labor practices, diversity and community involvement.
• Governance: This evaluates a company’s leadership and management, including board composition and shareholder rights.

Numerous independent research firms employ ESG scores to assess the ethical performance of investments. Investors seeking to build an environmentally focused impact portfolio often prioritize investments with high ESG ratings.

While ESG scores provide a snapshot of a company or fund’s sustainability efforts, it’s important to note that different organizations use varying methodologies, making direct comparisons difficult.

Socially responsible investing (SRI)

SRI, or socially responsible investing, is a similar concept to ESG. However, it often focuses on negative screening, meaning investors exclude companies — sometimes known as sin stocks — involved in certain industries or practices, such as tobacco, alcohol or weapons manufacturing.

A growing number of financial institutions now offer investment funds specifically designed to appeal to socially responsible investors.

Some robo-advisors offer automated portfolios aligned with social responsibility goals, making impact investing accessible to those without expert-level knowledge. Wealthfront, for example, offers a socially responsible portfolio with investments that increase exposure to companies receiving high scores on ESG factors.

Benefits of Impact Investing

Impact investing offers a range of benefits to both investors and society as a whole. For investors, it provides an opportunity to generate financial returns while also making a positive difference. It can also help to diversify portfolios and manage risks by investing in growing sectors.

For society, impact investing can lead to job creation, innovation and improved access to essential services, ultimately contributing to a more sustainable world.

How do impact investments perform financially?

A common misconception is that impact investing sacrifices financial returns for social good.

While past performance is never a prediction of future results, studies show that impact investments can generate competitive financial returns.

Portfolios incorporating ESG factors often show similar or better returns compared to traditional investments, according to an analysis by NYU Stern Center for Sustainable Business and Rockefeller Asset Management. The analysis, which reviewed over 1,000 research papers published between 2015 and 2020, noted that specifically low-carbon strategies also had positive financial outcomes.

A look at two popular ESG funds demonstrates that impact investing can generate competitive returns. The iShares ESG Aware MSCI USA ETF returned an average of 14.7 percent annually in the five years to August 2024. The iShares MSCI USA ESG Select ETF netted a similar 14.6 percent annualized returns over the same five-year period.

Examples of impact investing strategies

There are multiple ways to participate in impact investing, ranging from individual investments to large-scale institutional funds.

Some common strategies include:

• Investing in companies with a strong social or environmental mission: This could involve supporting renewable energy companies, affordable housing developers or health care providers serving underserved communities.
• Investing in impact funds: These funds pool capital from multiple investors and invest in a diversified portfolio of ESG or SRI companies.
• Community investing: This involves investing in local businesses and projects that contribute to community development.
• Impact bonds: These unique financial instruments offer investors the opportunity to finance social programs with the expectation of receiving a financial return if the program achieves its goals.

How to practice impact investing in 4 steps

Getting started with impact investing is easier than ever. Here are some steps to consider.

1. Define your impact goals

Identify the social or environmental issues you care about most. Are you passionate about climate change, education, health care or poverty alleviation? Your goals will shape your investment choices.

2. Decide how you want to invest

Do you want to take a DIY approach or let the pros (or robots) handle it for you?

While you can select individual investments, it demands extensive research. For a hands-off approach, robo-advisors offer socially responsible portfolios, some even specializing in specific impact areas.

To construct your own impact portfolio, a brokerage account is essential. Here’s a list of the best brokers to get you started.

3. Do your research

If you’re constructing a personalized impact investing portfolio, research is a must. Investors can manually select companies aligned with their values while excluding those that don’t meet their criteria.

But building and maintaining such a portfolio requires hands-on involvement, including ongoing monitoring of your investments. Diversification is key to mitigate risk, and most experts recommend a minimum of 10 different stocks for a well-diversified portfolio.

As you research individual companies, be aware of a practice known as greenwashing, a major challenge in the impact investing space. Many companies make exaggerated or false claims about their social and environmental impact. This deceptive practice can make it difficult for investors to objectively research a company’s impact on society or the environment.

For a clearer understanding, review the company’s impact report. This document outlines specific achievements, such as carbon footprint reductions or improved employee benefits, that demonstrate the investment’s real-world impact.

4. Select your impact investments

If you opt for the DIY route, you can buy mutual funds or ETFs with strong ESG scores, which will give you exposure to multiple companies at once. When evaluating impact investing funds, prioritize two key factors: The fund’s holdings (the specific companies it invests in) and its expense ratio (the annual fee charged to manage the fund).

While this diversification strategy can help mitigate risk, it’s essential to carefully consider the fund’s investment focus, since ESG and similar funds vary in their criteria. Some prioritize environmental factors, while others may emphasize social or governance issues.

MSCI provides one ESG rating model, assigning grades to companies on a scale from AAA to CCC. Individual investors can also use analysis tools, such as those found on platforms like Interactive Brokers, which offer comprehensive third-party ratings.

Bottom line

Ultimately, impact investing is about using your money to make a difference in the world while also earning a profit. There are many ways to implement the strategy, from set-it-and-forget-it automated portfolios to diligently researching and picking your own individual stocks. Whichever route you choose, stay informed about the companies you’re invested in and remain diversified.