In recent years, so called “ESG investing” has grown exponentially in acceptance among both individual and institutional investors. And investor excitement around renewable energy and EV stocks has reflected the mainstreaming of this approach, morphing into what is occasionally referred to as “Impact Investing”.
But is ESG investing really about making an impact? And if not, then where does an investor turn to do so? We believe that the Road Less Travelled — the Private Road, needs to be explored.
The terminology has always been imperfect
The two terms (ESG and Impact) are overlapping but hardly are synonymous. While ESG investing purports to study an investment’s Environmental, Social and Governance characteristics to identify risks and opportunities, such analysis does not in itself create, or even indicate, “impact”.
ESG analysis can identify risks inherent in an investment when management ignores such factors, and it can pinpoint those companies whose high standards reduce risks and place them above their peers. Portfolios are then constructed to have certain aggregate ESG characteristics, industry composition or other desired attributes. And the innovative financial services industry has embraced these investor preferences by delivering an ever-growing slate of strategies tailored to these needs.
Want a large cap fund focused on companies with more women on their boards? Gotcha. How about a low carbon or fossil fuel free portfolio? No problem. Equity or fixed income. Value or growth. There is usually an ESG mutual fund or ETF strategy to meet the investor need.
This is all great, but where is the impact?
This risk management exercise feels as if it is attempting to prevent a negative impact on society or to create a positive impact. But in reality, ESG investing is seldom actually about impact. It is more likely to be about alignment — between an investor’s values and their investments.
When an investor can sell the “traditional” stock or fund in the morning trading session and buy their ESG favorite before lunch, did they improve the world (i.e., make an impact) by their actions? Of course not. And that’s okay, of course. But don’t call it impact.
This not to knock “alignment” as an objective in its own right. All things equal, it is hard to argue that an investor’s free choice of investment types and specifics is not a valid objective. In theory, narrowing one’s investment choices should raise risk levels and reduce expected returns. But with proper portfolio construction, professionally managed investment funds have demonstrated that returns need not be harmed by various forms of “alignment”.
So, while actions in investors’ portfolio do not, on their own, create impact, companies surely generate positive (or negative) effects through their operations. The important distinction is that a company is going to make that impact with or without your name on the shareholder rolls. Ownership of shares, therefore, usually does not create impact without new capital being deployed to that investment.
The key to impact: Deploying new capital
Investors are therefore charged with finding impactful ways to deploy capital that brings something new to the table. Something incremental. This concept is known as “additionality”, and it is largely the provenance of private investments: Infrastructure projects, new ventures, growth equity and even debt finance that advances the growth of an enterprise. These all feature additionality. Even a failed early-stage venture can be argued to have advanced the state of commercialization of a new technology that ultimately makes that sought after impact possible.
The determination of additionality can be a complex one. Investors need to examine what the new capital helps to accomplish. Will this new money create, for instance, clean energy that will displace dirtier energy sources, or finance a new company with a novel solution to food waste? Does this capital underpin ventures to improve the human condition through education, nutrition, access to finance or to technology? This short list shows that the opportunities are highly varied and potentially quite vast.
Altera is proud to have researched each of the above investment types and has sponsored several for our clients. Our view is that one need not sacrifice financial returns when pursuing an impact investment strategy. We employ the same principles to our analysis, evaluation and even performance benchmarking of an impact opportunity, and we don’t lower our target return objectives. On the contrary, one can argue that some of the best opportunities are at the intersection of technology and societal challenges. The most overlooked opportunities often reside in less-travelled regions (including the Southeast) or among female entrepreneurs, or with fund managers of color.
At Altera, we understand that investors look to us for both measurable social impact and a competitive financial return. Our bias is to favor investments that target “market-rate returns” — that is, returns that are competitive with traditional (non-impact) investments in the same asset class.
Ultimately, each investor has the responsibility for deciding where they wish to be on the scale of impact versus financial return. Just as investors accept lower returns on low volatility securities, so too can one consider opportunities to make an outsized impact and earn a below-rate return on some of their holdings.
A “portfolio approach” to impact investments might be advantageous, incorporating high potential venture capital funds alongside more stable credit strategies and even high-impact (but lower yielding) microfinance vehicles. By balancing a variety of performance drivers, risk levels, impact categories, target returns and asset durations, a robust impact portfolio can be created to accomplish a wide array of the investor’s financial and social impact objectives.
As investors seek to balance their financial requirements and “alignment” needs with their “impact” objectives, it is clear that private investments are the avenue to more explicitly accomplishing the latter. Not every investor has access to, or is familiar with, private investing. But for those whose wealth levels and liquidity needs are consistent with the characteristics of the chosen vehicle, the Private
Road is one that certainly needs to be explored.
By: Scott Sadler, CFA
Director of Impact Strategies