Alternative investment strategies to target sustainable yield
15 July 20
15 July 20
We are facing major challenges today that have been escalated by the development of the coronavirus crisis. Triple Point’s Julian Pickstone explores the key characteristics of impact investing and its objective as an investment approach, marrying societal and environmental impact with long term financial returns.
The purest and most comprehensive form of Responsible Investing (‘RI’) is impact investing. It involves investing money, with the same financial scrutiny as traditional investments, to produce quantifiable social or environmental benefits with the aim of generating financial returns. As such impact investing effectively fuses traditional investing with sustainable objectives and practices.
In the most rigorous sizing of the market to date, the Global Impact Investing Network “GIIN” found that in 2019 over 1340 organisations manage over $502bn in impact investing assets worldwide. What’s more, over 50% of active impact investing organisations made their first investment only within the last decade.
Surge in investor demand
Among investors, demand is being reflected in mainstream allocators changing their focus away solely from financial returns to pursuing investments with wider positive outcomes. The rationale is hard to denythe evidence suggests that impact investing can withstand the same scrutiny as traditional investments.
The market for impact investing has seen new entrants and larger portfolio allocations from existing players already operating in this area. According to a 2019 survey of more than 6,000 people, run by the Department for International Development, more than 70 per cent want their own investments to achieve good for people and the planet. Additionally, In the first impact investing market analysis of its type, it was found that 83% of Nordic investors, investing in impact, expect their impact portfolio to deliver at or above the market rate of return.
For many retail investors, perhaps further incentivised by these statistics, whose contribution to environmental and socially beneficial investments could be significant, this is an industry in need of demystification. This is a marketplace that is experiencing explosive growth and is clearly attracting the attention of mainstream investors.
Although Impact investing comes in a variety of forms it is important to establish what it is not. Unlike other subsets of responsible investing (‘RI’), impact investing does not describe attempts to avert harm by avoiding certain industries or sectors, which could include fossil fuel companies, tobacco firms or weapons manufacturers. Rather, impact investing takes an active role, targeting investments with real purpose to benefit society and deliver investment returns.
Currently, Impact investing is more common in venture capital, private equity and private credit because closed-end funds deploying patient capital can invest in long term impact opportunities such as infrastructure, clean water or social housing.
The logic is that the long-term risk-adjusted returns are superior because the investment approach is in tune with the forces shaping the global economy. For example, the intensified role of the climate change agenda, the drive for reducing poverty, addressing inequality and expanding global access to quality healthcare and education. There is now growing evidence that companies successful in enforcing strategies to create profit-driven social impact can deliver superior shareholder returns. Research carried out by the London Business School demonstrates that companies which decide to improve sustainability in an area that is material to their business, for example fossil fuel companies focusing on mitigating environmental damage, delivered higher returns over time than peers who ignored it.
Limitations of ESG
Perhaps the most common form of Responsible Investing is the use of environmental, social and governance factors. This is normally abbreviated by the acronym ‘ESG’. An example of what this looks like in practice might be choosing between two energy stocks according to ESG criteria. In this case the investment manager would choose the company that produces more renewable energy than power from fossil fuels.
Operating an investment strategy according to ESG factors infers the idea that they can affect investment returns and produce outperformance. In some ways this is fairly intuitive. Indeed, a company that’s well managed is likely to do better than one that’s not. As risk factors, ESG criteria can also describe the risks that a business’ particular operations may not be sustainable in the long term because of environmental damage they may cause.
Some investment managers actually assert that integrating ESG factors into a strategy can improve its returns. This might be through reducing risk or from selecting stocks that perform well. Indeed, for these reasons, some have claimed that ESG is not the product of moral investing but is a case of portfolio optimisation.
The Importance of Impact Measurement
There is a growing demand for fund managers and pension schemes to be equipped with clear and standardised tools for measuring the social impact of their investments.
Greenwashing is a key threat to the wider adoption and success of RI. By declaring an investment strategy as green, ESG compliant or sustainable just to secure more customers and investors, this prevents genuine societal and environmental solutions to the most significant challenges we face.
Frustratingly most of the due diligence burden to establish whether investment products are actually RI compliant is borne by investors, but regulators are working to establish harmonised and broad-based codes of conduct to try to help them. These include the 2018 proposals from the European Commission to create an EU classification system. In December, EU negotiators announced they had agreed a deal to establish common European rules over what can be considered a green investment, in what was hailed as the first concerted attempt to define what counts as a sustainable investment. The categorisation system to decide which financial products could be marketed as green will be included in a rule book, which will cover all types of energy sources including nuclear and will inform how investors treat a range of assets from green bonds to bank loans and investment products.
However, whilst this is a step in the right direction in providing the basis of a common framework, these systems are still broad, and act more as a benchmark rather than a quantifiable strategy. Impact Investing is different from other RI approaches because it is concerned with developing and sharing the best practices for impact measurement, management and reporting. By following a clearer approach to measurement and reporting, this encourages investors to demand better insight into the investments made on their behalf and ensures the capital they commit has the maximum positive impact, for their benefit and for society as a whole.
Ultimately, Responsible Investing will continue to grow as it reflects broader environmental and sustainable concerns among investors and society as a whole – factors only further enforced by the COVID-19 pandemic. There is now urgency for investors to see their values reflected in investments. This means more asset managers are having to think about adopting their own RI policies. Whilst there are many variations and applications of RI, all with their particular issues, impact investing remains the approach, which is the most capable of meeting a growing investor and government demand driven by values and macro-economic risks. Expect it to increasingly become the norm among investors in the years to come.