When it was coined just a decade ago, the term ‘impact investing’ referred to early-stage investments in unlisted social enterprises. Ten years later, its scope has exploded.
Gone is the stereotype of foreign direct investment into concessionary projects in far-flung locations. Today’s impact investors represent over $502 billion globally, with the type of investments made and capital deployed growing rapidly.
The burgeoning demand isn’t hard to understand. Investing for positive social and environmental impact as well as a financial return is an attractive concept, particularly as the world begins to wake up to issues such as climate change and social inequality. Who wouldn’t say yes to triple-bottom-line returns?
So it’s little surprise that impact investing, traditionally associated with private markets, is now being adopted into new asset classes.
As defined by the Global Impact Investing Network, the two pillars of impact investing are intentionality (the stated intention to have a positive social or environmental impact) and measurability (the ability to measure the social or environmental impact of an investment).
To that end, there are only two broad requirements for any impact portfolio, be it an active fixed income or equity index fund.
First, it must have a stated investment thesis. For instance, where a UK growth fund will include all UK growth stocks, a UK growth clean water fund will include all UK growth stocks that fit the parameters of the impact theme (in this case, clean water).
Second, it should be able to measure—and report on—its social and environmental impact, be that in quantitative or qualitative terms.
What unites both steps is a dependence on high-quality impact data, which is used both to identify stocks or issuers that qualify under the banner of an impact investment thesis and to monitor the risk exposure of the portfolio on a regular basis.
So far, so straightforward. Despite surface-level similarities, however, impact doesn’t look identical across the board.
Which brings us to what we consider the third pillar of impact investing: activity.
Activity—the series of processes translating intention into impact within any portfolio—is variable, with fund managers across different asset classes achieving impact in different ways.
In no particular order, this is how it's done.
Most frequently associated with impact, active equity fund managers use impact data to optimise existing portfolios and build new ones. They have three levers at hand.
The first is the most popular: screening. Using impact data, investors can build rules-based impact parameters to either screen out ‘negative’ sectors or tilt towards ‘positive’ ones as measured against a broad range of social and environmental criteria.
The second lever is stock selection, which relies on more forensic analysis. Using granular analytics, a portfolio manager can explore any company’s impact across different themes and measured against other companies. This makes it possible not only to confirm or negate existing hypotheses about a company’s impact but also to generate new—potentially investable—ideas.
Finally, engagement. Impact data provides insight into how a company affects people and planet, which forms a springboard from which investors can engage with companies. For instance, a company whose products are shown to be negatively affecting biodiversity can be encouraged to fund research and development into products that have a more environmentally friendly impact.
The active equity manager’s ability to screen, select and engage on the basis of a company’s social and environmental impact puts a considerable amount of pressure on companies to redirect operations and spending towards positive outcomes. If they don’t, their cost of capital will increase, signalling a higher level of risk and making it harder to fund new projects.
As controlling equity investors, private equity managers are able to go a step further. Impact data can inform their decisions about a company’s management, business and spending decisions, with a view to driving it towards better social and environmental outcomes.
There’s still a misperception that passive managers can’t use impact taxonomies such as the UN Sustainable Development Goals (SDGs) because their stock exposure is determined by the underlying index.
In reality, however, passive managers can use impact data to tweak existing funds, build new ones and—as with active fund managers—engage with their investee companies.
Like their active peers, passive managers can use impact data to screen out certain stocks that don’t align with their sustainability goals. But they can also go one step further.
Working with index builders, passive managers can build thematic or holistic indexes and, on top of that, an almost limitless variety of sustainable index products, including ETFs, smart-beta funds or index funds. For example, an index fund house could build a family of indexes centred on a theme such as ‘renewable energy’, with a number of related products for different clients and geographies.
In this case, robust impact data is critical to minimise the financial and resource cost of rebalancing and re-weighting indexes.
Whether or not they’re included in an index, companies assessed against impact metrics have significant impetus to perform well.
Passive managers can and do engage with the companies held in an index. In fact, there’s an argument to be made that passive managers have more clout because they can’t simply divest when companies are underperforming on a social or environmental metric. Instead, they take an approach of continuous engagement.
This pressure can be more effective in redirecting business models and spending towards better outcomes: for example, encouraging a tobacco company to develop products that have a better effect on health.
Most importantly—and even if it doesn’t respond to shareholder pressure—if a company is dropped from an index, the cost of its capital may increase. To re-enter the index, it must then change its behaviour.
Quant and hedge strategies aren’t typically associated with impact or even ESG. But while it’s early days, the availability of material social and environmental data makes impact more plausible for mission-led or activist hedge and quant funds.
Quant and hedge funds use a variety of data inputs to value stocks and find instances of mispricing. Incorporated into the investment process, an impact dataset can be used by algorithms and natural language processing to determine company information and trends that can also be analysed at a sector or country level.
Hedge funds can use impact data in one other way. Hedging—or taking short positions—is at the core of the strategy’s ethos. The traditional impact investment approach of screening out a stock or sector is effectively being short that exposure. A simple impact hedge fund strategy could amplify that view by co-opting the screening process, going long ‘positive’ and short ‘negative’ impact.
Activist hedge funds make a large enough investment in a company to participate in management and business decision making over the long run, much like private equity funds but within public markets. As such, they can effect meaningful improvements by directing company operations towards more socially and environmentally positive ends.
On the other hand, companies that are seen to be higher risk as a result of their poor real-world impact are likely to see an increased cost of capital, making it more difficult to fund (most likely negative-impact) projects.
Fixed income is another one that hasn't, historically, been associated with ESG or impact. Credit ratings agencies have been notoriously slow to integrate non-financial analysis into credit ratings.
In the case of corporate debt, however, that’s beginning to change.
Corporate debt fund managers can, not unlike equity managers, use impact data to screen out issuers on a relative (i.e. in terms of revenue) or absolute basis.
But the most obvious way in which fixed-income investors can incorporate impact into their approach is by investing in securities that have a direct link to a sustainable project. The best example is green bonds, the proceeds of which are used to fund specific environmentally friendly projects.
It’s not just that policy and client demand have converged. The direct physical impact of social and environmental events such as climate change can negatively affect fixed income market pricing, volatility and financial stability. These risks are more amplified for certain geographies and industries.
Despite a lingering stereotype, the impact investor defies pigeonholing. The most optimistic estimates suggest all investing will be executed with a sustainability lens in the decades to come.
While they may diverge, different approaches are underpinned by a singular belief: the idea that financial returns can no longer be appraised in silo. The impact of an investment on people and planet matters, too.
Which should be something everyone can get behind.